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Return Concepts

Return Concepts. Presenter Venue Date. Why Focus on Return Concepts?. Holding Period Return. Other Return Concepts. Equity Risk Premium. Equity Risk Premium Estimates. Historical Estimates Forward-Looking Estimates Gordon growth model estimates Macroeconomic model estimates

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Return Concepts

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  1. Return Concepts Presenter Venue Date

  2. Why Focus on Return Concepts?

  3. Holding Period Return

  4. Other Return Concepts

  5. Equity Risk Premium

  6. Equity Risk Premium Estimates • Historical Estimates • Forward-Looking Estimates • Gordon growth model estimates • Macroeconomic model estimates • Survey estimates

  7. 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

  8. Historical Equity Risk Premium Estimates

  9. Forward-Looking Equity Risk Premium Estimates

  10. Forward-Looking Equity Risk Premium Estimates Macroeconomic Model Equity Risk Premium (ERP)

  11. Example: Forward-Looking Equity Risk Premium

  12. Example: Forward-Looking Equity Risk Premium

  13. Example: Forward-Looking Equity Risk Premium

  14. Example: Forward-Looking Equity Risk Premium

  15. Estimating the Required Return on an Equity Investment

  16. Capital Asset Pricing Model(CAPM) • 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 mean–variance optimization • Relevant risk is systematic risk

  17. Beta Estimation Issues

  18. Multifactor Models:Fama–French Model

  19. Fama–French Model • where • SMB = The return to small stocks minus the return to large stocks • βsize = The sensitivity of security i to movements in small stocks • HML = The return to value stocks minus the return to growth stocks • β value = The sensitivity of security i to movements in value stocks PASTOR–STAMBAUGH MODEL • where • LIQ = The return to illiquid stocks minus the return to liquid stocks • β liq = The sensitivity of security i to movements in illiquid stocks

  20. Example: Fama–French Model

  21. Example: Fama–French Model

  22. 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

  23. International Considerations for Required Returns

  24. Weighted Average Cost of Capital

  25. Weighted Average Cost of Capital • 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

  26. Example: Weighted Average Cost of Capital

  27. Example: Weighted Average Cost of Capital

  28. Choice of Discount Rate

  29. Summary

  30. Summary

  31. Summary

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