65 An Updated Equity Risk Premium: January 2015 Base year cash flow (last 12 mths) Dividends (TTM): 38.57 + Buybacks (TTM): 61.92 = Cash to investors (TTM): 100.50 Earnings in TTM: 114.74 100.5 growing @ 5.58% a year Expected growth in next 5 years Top down analyst estimate of earnings growth for S&P 500 with stable payout: 5.58% E(Cash to investors) S&P 500 on 1/1/15= 2058.90 106.10 112.01 118.26 124.85 131.81 2058.90 = 106.10 (1+ r) + 112.91 (1+ r) 2 + 118.26 (1+ r) 3 + 124.85 (1+ r) 4 + 131.81 (1+ r) 5 + 131.81(1.0217) (r.0217)(1+ r) 5 r = Implied Expected Return on Stocks = 7.95% Minus Beyond year 5 Expected growth rate = Riskfree rate = 2.17% Expected CF in year 6 = 131.81(1.0217) Risk free rate = T.Bond rate on 1/1/15= 2.17% Equals Implied Equity Risk Premium (1/1/15) = 7.95% - 2.17% = 5.78% 65
Implied Premiums in the US: 1960-2014 66 Implied Premium for US Equity Market: 1960-2014 7.00% 6.00% 5.00% Implied Premium 4.00% 3.00% 2.00% 1.00% 0.00% 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975 1974 1973 1972 1971 1970 1969 1968 1967 1966 1965 1964 1963 1962 1961 1960 Year 66
Implied Premium versus Risk Free Rate 67 Implied ERP and Risk free Rates 25.00% 20.00% Expected Return on Stocks = T.Bond Rate + Equity Risk Premium 15.00% 10.00% Implied Premium (FCFE) Since 2008, the expected return on stocks has stagnated at about 8%, but the risk free rate has dropped dramatically. 5.00% T. Bond Rate 0.00% 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 67
Equity Risk Premiums and Bond Default Spreads 68 Figure 16: Equity Risk Premiums and Bond Default Spreads Premium (Spread) 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 ERP / Baa Spread ERP/Baa Spread Baa - T.Bond Rate ERP 68
69 Equity Risk Premiums and Cap Rates (Real Estate) Figure 17: Equity Risk Premiums, Cap Rates and Bond Spreads 8.00% 6.00% 4.00% 2.00% 0.00% - 2.00% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 ERP Baa Spread Cap Rate premium - 4.00% - 6.00% - 8.00% 69
Why implied premiums marer? 70 In many investment banks, it is common pracwce (especially in corporate finance departments) to use historical risk premiums (and arithmewc averages at that) as risk premiums to compute cost of equity. If all analysts in the department used the arithmewc average premium (for stocks over T.Bills) for 1928-2014 of 8% to value stocks in January 2014, given the implied premium of 5.75%, what are they likely to find? a. The values they obtain will be too low (most stocks will look overvalued) b. The values they obtain will be too high (most stocks will look under valued) c. There should be no systemawc bias as long as they use the same premium to value all stocks. 70
Which equity risk premium should you use? 71 If you assume this Premiums revert back to historical norms and your Wme period yields these norms Market is correct in the aggregate or that your valuawon should be market neutral Premium to use Historical risk premium Current implied equity risk premium Marker makes mistakes even in the aggregate but is correct over Wme Average implied equity risk premium over Wme. 71
And the approach can be extended to emerging markets Implied premium for the Sensex (September 2007) 72 Inputs for the computawon Sensex on 9/5/07 = 15446 Dividend yield on index = 3.05% Expected growth rate - next 5 years = 14% Growth rate beyond year 5 = 6.76% (set equal to riskfree rate) Solving for the expected return: 15446 = 537.06 (1+ r) + 612.25 (1+ r) 2 + 697.86 (1+ r) 3 + 795.67 (1+ r) 4 + 907.07 (1+ r) 5 + 907.07(1.0676) (r.0676)(1+ r) 5 Expected return on stocks = 11.18% Implied equity risk premium for India = 11.18% - 6.76% = 4.42% 72
73 Can country risk premiums change? Brazil CRP & Total ERP from 2000 to 2013 Figure 15: Implied Equity Risk Premium - Brazil 9.00% 8.00% 0.69% Risk Premium 7.00% 6.00% 5.00% 3.15% 4.06% 4.00% 3.00% 2.00% 2.50% 1.00% 4.00%4.31% 3.23% 3.70% 2.28% 0.82% 2.43% 0.86% 0.70% 3.51% 4.05% 4.12%3.95%3.88%3.95%4.04% 4.55%4.86%5.10% 7.64% 0.65% 1.34%1.87% 6.35% 5.59% 5.28% Brazil Country Risk US premium 0.00% 73
The evoluwon of Emerging Market Risk 74 74
Measuring Relative Risk MPT Quadrant Sector-average Beta Average regression beta across all companies in the business(es) that the firm operates in. Price Variance Model Standard deviation, relative to the average across all stocks Debt cost based Estimate cost of equity based upon cost of debt and relative volatility APM/ Multi-factor Models Estimate 'betas' against multiple macro risk factors, using past price data The CAPM Beta Regression beta of stock returns at firm versus stock returns on market index Relative Risk Measure How risky is this asset, relative to the average risk investment? Accounting Earnings Volatility How volatile is your company's earnings, relative to the average company's earnings? Accounting Risk Quadrant Accounting Earnings Beta Regression beta of changes in earnings at firm versus changes in earnings for market index Balance Sheet Ratios Risk based upon balance sheet ratios (debt ratio, working capital, cash, fixed assets) that measure risk Price based, Model Agnostic Quadrant Implied Beta/ Cost of equity Estimate a cost of equity for firm or sector based upon price today and expected cash flows in future Proxy measures Use a proxy for risk (market cap, sector). Composite Risk Measures Use a mix of quantitative (price, ratios) & qualitative analysis (management quality) to estimate relative risk Intrinsic Risk Quadrant 75
The CAPM Beta 76 The standard procedure for eswmawng betas is to regress stock returns (Rj) against market returns (Rm) - Rj = a + b Rm where a is the intercept and b is the slope of the regression. The slope of the regression corresponds to the beta of the stock, and measures the riskiness of the stock. This beta has three problems: It has high standard error It reflects the firm s business mix over the period of the regression, not the current mix It reflects the firm s average financial leverage over the period rather than the current leverage. 76
Beta EsWmaWon: The Noise Problem 77 77
Beta EsWmaWon: The Index Effect 78 78
79 Stock- priced based soluwons to the Regression Beta Problem Modify the regression beta by changing the index used to eswmate the beta adjuswng the regression beta eswmate, by bringing in informawon about the fundamentals of the company EsWmate the beta for the firm using the standard deviawon in stock prices instead of a regression against an index RelaWve risk = Standard deviawon in stock prices for investment/ Average standard deviawon across all stocks EsWmate the beta for the firm from the borom up without employing the regression technique. This will require understanding the business mix of the firm eswmawng the financial leverage of the firm Imputed or implied beta (cost of equity) for the sector. 79
AlternaWve measures of relawve risk for equity 80 AccounWng risk measures: To the extent that you don t trust market- priced based measures of risk, you could compute relawve risk measures based on AccounWng earnings volawlity: Compute an accounwng beta or relawve volawlity Balance sheet rawos: You could compute a risk score based upon accounwng rawos like debt rawos or cash holdings (akin to default risk scores like the Z score) Proxies: In a simpler version of proxy models, you can categorize firms into risk classes based upon size, sectors or other characteriswcs. QualitaWve Risk Models: In these models, risk assessments are based at least parwally on qualitawve factors (quality of management). Debt based measures: You can eswmate a cost of equity, based upon an observable costs of debt for the company. Cost of equity = Cost of debt * Scaling factor 80
Determinants of Betas & RelaWve Risk 81 Beta of Equity (Levered Beta) Nature of product or service offered by company: Other things remaining equal, the more discretionary the product or service, the higher the beta. Beta of Firm (Unlevered Beta) Operating Leverage (Fixed Costs as percent of total costs): Other things remaining equal the greater the proportion of the costs that are fixed, the higher the beta of the company. Financial Leverage: Other things remaining equal, the greater the proportion of capital that a firm raises from debt,the higher its equity beta will be Implciations Highly levered firms should have highe betas than firms with less debt. Equity Beta (Levered beta) = Unlev Beta (1 + (1- t) (Debt/Equity Ratio)) Implications 1. Cyclical companies should have higher betas than noncyclical companies. 2. Luxury goods firms should have higher betas than basic goods. 3. High priced goods/service firms should have higher betas than low prices goods/services firms. 4. Growth firms should have higher betas. Implications 1. Firms with high infrastructure needs and rigid cost structures should have higher betas than firms with flexible cost structures. 2. Smaller firms should have higher betas than larger firms. 3. Young firms should have higher betas than more mature firms. 81