An#Updated#Equity#Risk#Premium:#January# 2015adamodar/podcasts/valfall15/val...65...

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65 An Updated Equity Risk Premium: January 2015 Aswath Damodaran 65 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 Expected growth in next 5 years Top down analyst estimate of earnings growth for S&P 500 with stable payout: 5.58% 106.10 112.01 118.26 124.85 131.81 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% r = Implied Expected Return on Stocks = 7.95% S&P 500 on 1/1/15= 2058.90 E(Cash to investors) Minus Implied Equity Risk Premium (1/1/15) = 7.95% - 2.17% = 5.78% Equals 100.5 growing @ 5.58% a year 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

Transcript of An#Updated#Equity#Risk#Premium:#January# 2015adamodar/podcasts/valfall15/val...65...

Page 1: An#Updated#Equity#Risk#Premium:#January# 2015adamodar/podcasts/valfall15/val...65 An#Updated#Equity#Risk#Premium:#January# 2015 Aswath Damodaran 65 Base year cash flow (last 12 mths)

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An  Updated  Equity  Risk  Premium:  January  2015    

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Base year cash flow (last 12 mths)Dividends (TTM): 38.57+ Buybacks (TTM): 61.92

= Cash to investors (TTM): 100.50Earnings in TTM: 114.74

Expected growth in next 5 yearsTop down analyst estimate of earnings

growth for S&P 500 with stable payout: 5.58%

106.10 112.01 118.26 124.85 131.81 Beyond year 5Expected 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%

r = Implied Expected Return on Stocks = 7.95%

S&P 500 on 1/1/15= 2058.90

E(Cash to investors)

Minus

Implied Equity Risk Premium (1/1/15) = 7.95% - 2.17% = 5.78%

Equals

100.5 growing @ 5.58% a year

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

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Implied  Premiums  in  the  US:  1960-­‐2014  

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Implied  Premium  versus  Risk  Free  Rate  

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Implied ERP and Risk free Rates

Implied Premium (FCFE)

T. Bond Rate

Expected Return on Stocks = T.Bond Rate + Equity Risk Premium

Since 2008, the expected return on stocks has stagnated at about 8%, but the risk free rate has dropped dramatically.

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Equity  Risk  Premiums  and  Bond  Default  Spreads  

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Figure 16: Equity Risk Premiums and Bond Default Spreads

ERP/Baa Spread Baa - T.Bond Rate ERP

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Equity  Risk  Premiums  and  Cap  Rates  (Real  Estate)  

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Figure  17:  Equity  Risk  Premiums,  Cap  Rates  and  Bond  Spreads    

ERP  

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Why  implied  premiums  maRer?  

¨  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.  

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Which  equity  risk  premium  should  you  use?  

If  you  assume  this   Premium  to  use  

Premiums  revert  back  to  historical  norms  and  your  Wme  period  yields  these  norms  

Historical  risk  premium  

Market  is  correct  in  the  aggregate  or  that  your  valuaWon  should  be  market  neutral  

Current  implied  equity  risk  premium  

Marker  makes  mistakes  even  in  the  aggregate  but  is  correct  over  Wme  

Average  implied  equity  risk  premium  over  Wme.  

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And  the  approach  can  be  extended  to  emerging  markets  Implied  premium  for  the  Sensex  (September  2007)  

¨  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:  

¨  Expected  return  on  stocks  =  11.18%  ¨  Implied  equity  risk  premium  for  India  =  11.18%  -­‐  6.76%  =  

4.42%  €

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

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Can  country  risk  premiums  change?  Brazil  CRP  &  Total  ERP  from  2000  to  2013  

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Figure 15: Implied Equity Risk Premium - Brazil

Brazil Country Risk

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The  evoluWon  of  Emerging  Market  Risk  

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Relative Risk MeasureHow risky is this asset, relative to the average

risk investment?

The CAPM BetaRegression beta of

stock returns at firm versus stock returns on market

index

Price Variance ModelStandard deviation, relative to the

average across all stocks

Accounting Earnings VolatilityHow volatile is your company's

earnings, relative to the average company's earnings?

Accounting Earnings BetaRegression beta of changes

in earnings at firm versus changes in earnings for

market index

Sector-average BetaAverage regression beta

across all companies in the business(es) that the firm

operates in.

Proxy measuresUse a proxy for risk (market cap, sector).

Debt cost basedEstimate cost of equity based upon cost of debt and relative

volatility

Balance Sheet RatiosRisk based upon balance

sheet ratios (debt ratio, working capital, cash, fixed assets) that measure risk

Implied Beta/ Cost of equityEstimate a cost of equity for firm or sector based upon price today and expected

cash flows in future

Composite Risk MeasuresUse a mix of quantitative (price,

ratios) & qualitative analysis (management quality) to

estimate relative risk

APM/ Multi-factor ModelsEstimate 'betas' against

multiple macro risk factors, using past price data

MPT Quadrant

Price based, Model Agnostic Quadrant

Accounting Risk Quadrant

Intrinsic Risk Quadrant

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Measuring Relative Risk

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The  CAPM  Beta  

¨  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.  

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Beta  EsWmaWon:  The  Noise  Problem  

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Beta  EsWmaWon:  The  Index  Effect  

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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.    

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AlternaWve  measures  of  relaWve  risk  for  equity  

¨  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  

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Determinants  of  Betas  &  RelaWve  Risk  

Beta of Firm (Unlevered Beta)

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.

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

Implications1. Cyclical companies should have higher betas than non-cyclical 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.

Implications1. 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.

ImplciationsHighly levered firms should have highe betas than firms with less debt.Equity Beta (Levered beta) = Unlev Beta (1 + (1- t) (Debt/Equity Ratio))

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