Fundamentals of Valuation

Chapter TWO: Return Concepts

3.1 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. The equity risk
premium, like the required return, depends strictly on
expectations for the future because the investor’s returns
depend only on the investment’s future cash flows.
Possibly confusingly, 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.
3.2. Required Return on Equity
 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)
 3.2. Historical Estimates of Equity premium

 In A historical equity risk premium estimate is usually calculated as the mean value
of the differences between broad-based equity-market-index returns and
government debt returns over some selected sample period. When reliable long-
term records of equity returns are available, historical estimates have been a
familiar and popular choice of estimation. If investors do not make systematic errors
in forming expectations, then, over the long term, average returns should be an
unbiased estimate of what investors expected. The fact that historical estimates are
based on data also gives them an objective quality.
 3.3. Forward-Looking Estimates
 Because the equity risk premium is based only on expectations for economic and
financial variables from the present going forward, it is logical to estimate the
premium directly based on current information and expectations concerning such
variables. Such estimates are often called forward-looking or ex ante estimates.
In principle, such estimates may agree with, be higher, or be lower than
historical equity risk premium estimates.
 3.3.1. Gordon Growth Model Estimates
 GGM equity risk premium estimate
 =Dividend yield on the index based on year-ahead aggregate forecasted
 dividends and aggregate market value
 +Consensus long-term earnings growth rate
 −Current long-term government bond yield
2.4. EX on GGM estimates
 We can illustrate with the case of the United States. As of July 2013, the
dividend yield on the S&P 500 as defined in Equation 6 was approximately
2.1 percent based on a price level of the S&P 500 of 1,685.73, reported
earnings have grown at approximately a 7 percent rate over the last four
decades.
 We will use the 7 percent long-term average growth rate as the long-term
earnings growth forecast. Dividend growth should track earnings growth over
the long term. The 20-year US government bond yield was 3.0 percent.
Therefore, according to last Equation, the Gordon growth model estimate of
the US equity risk premium was 2.1% + 7.0% – 3.0% or 6.1%.
2.5 The Required Return on Equity
 With means to estimate the equity risk premium in hand,
the analyst can estimate the required return on the equity
of a particular issuer. The choices include the following:
 • the CAPM;
 • a multifactor model such as the Fama–French or related
models; and
 • a build-up method, such as the bond yield plus risk
premium method.
2.5.1 The Capital Asset Pricing Model
 The CAPM is an equation for required return that should
hold in equilibrium (the condition in which supply equals
demand) if the model’s assumptions are met; among the
key assumptions are that investors are risk averse and
that they make investment decisions based on the mean
return and variance of returns of their total portfolio. The
chief insight of the model is that investors evaluate the
risk of an asset in terms of the asset’s contribution to the
systematic risk of their total portfolio (systematic risk is
risk that cannot be shed by portfolio diversification).
Because the CAPM provides an economically grounded and
relatively objective procedure for required return
estimation, it has been widely used in valuation.
CAPM
 The expression for the CAPM that is used in practice was given earlier
as Equation
 Required return on share i = Current expected risk-free return +
β1(Equity risk premium)
 For example, if the current expected risk-free return is 3 percent, the
asset’s beta is 1.20, and the equity risk premium is 4.5 percent, then
the asset’s required return is
 Required return on share i = 0.030 + 1.20(0.045) = 0.084 or 8.4
percent
2.5.2 Multifactor Models
 Whereas the CAPM adds a single risk premium to the risk-free rate,
arbitrage pricing theory (APT) models add a set of risk premia. APT
models are based on a multifactor representation of the drivers of
return. Formally, APT models express the required return on an
 asset as follows:
 R = RF + 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚1 + 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚2 +----- 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚𝑘
 where (Risk premium)i = (Factor sensitivity)i × (Factor risk premium)i.
2.5.3 The Fama–French Model

 By the end of the 1980s, empirical evidence had accumulated that, at least
over certain long time periods, in the US and several other equity markets,
investment strategies biased toward small-market capitalization securities
and/or value might generate higher returns over the long-run than the CAPM
predicts.
 In 1993, researchers Eugene Fama and Kenneth French addressed these
perceived weaknesses of the CAPM in a model with three factors, known as
the Fama–French model
 The FFM is among the most widely known non-proprietary multifactor models.
The factors are:
2.5.3 The Fama–French Model
 • RMRF, standing for RM – RF, the return on a market value-weighted
equity index in excess of the one-month T-bill rate—this is one way
the equity risk premium can be represented and is the factor shared
with the CAPM.
 • SMB (small minus big), a size (market capitalization) factor. SMB is
the average return on three small-cap portfolios minus the average
return on three large-cap portfolios. Thus SMB represents a small-cap
return premium.
 • HML (high minus low), the average return on two high book-to-
market portfolios minus the average return on two low book-to-
market portfolios.44 With high book-to-market (equivalently, low
price-to-book) shares representing a value bias and low book-to-
market representing a growth bias, in general, HML represents a value
return premium.
Fama-French Model
 ri = RF + 𝑏𝑖 𝑀𝐾𝑇 rMrF + 𝑏𝑖 𝑠𝑖𝑧𝑒 SMB + 𝑏𝑖 𝑣𝑎𝑙𝑢𝑒 hML
 We can illustrate the FFM using the case of the US equity market. Assume the
short-term interest rate is 0.03 percent. Historical market, size, and value
premiums based on Fama–French data from 1926 to 2012 are 5.9 percent, 2.6
percent, and 4.1 percent, respectively.
 However, over the last quarter century (1986 to 2012) the realized SMB
premium has averaged 0.3 percent and the realized HML premium has
averaged 2.7 percent while the average RMRF has remained at 5.9 percent.
Thus, based on risk premiums for the last 25 years, one estimate of the FFM
expected return for the US market as of year-end 2012 is:
 ri = 0.0003 + 𝐵𝑖 𝑀𝐾𝑇 0.059 + 𝐵𝑖 𝑆𝑖𝑧𝑒 0.003 + 𝐵𝑖 𝑉𝑎𝑙𝑢𝑒 0.027
Fama-French Model
 Consider the case of a small-cap issue with value characteristics and
above-average market risk—assume the FFM market beta is 1.20. If
the issue’s market capitalization is small, we expect it to have a
positive size beta; for example, size Beta = 0.5. If the shares sell
cheaply in relation
 to book equity (i.e., they have a high book-to-market ratio), the value
beta is also expected to be positive; for example, value Beta = 0.8.
For both the size and value betas, zero is the neutral value, in
contrast with the market beta, where the neutral value is 1. Thus,
according to the FFM, the shares’ required return is close to 10
percent:
 ri = 0.0003 + 1.20(0.059) + 0.5(0.003) + 0.8(0.027) = 0.0942
Thank You