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CFA Level 2 2015 - Equity - Reading 29 - Return Concepts
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Terms in this set (31)
6 types of return
- Holding period return
- Realized (historical return) and expected holding period return (based on forecasts of future prices)
- Required return (the minimum return an investor requires given the asset's risk, also called the opportunity cost). If expected return is greater than required return, the asset is undervalued
- Price convergence: if the expected return is not equal to required return, there can be a return from convergence of price to intrinsic value
- Discount rate: the rate used to find the PV of an investment
- Internal Rate of Return: market-determined rate for publicly traded securities. If markets are efficient, then the IRR represents the required return
Price appreciation return (or capital gains yield)
Required return - dividend yield
Expected return =
Required return + return from convergence
Expected alpha =
Expected return - required return
Realized alpha =
Actual HPR - required return
Equity risk premium
ERP = required return on equity index - riskfree rate
Required return for stock j =
riskfree rate + βj * ERP
(2) Required return for stock j =
riskfree rate + ERP + other risk premia/discounts for j
(buildup method)
Target price
Target Price = Current Price x (1+required return) - Dividend
OR
Target Price = Required Return - Dividend Yield
2 Ways to estimate the ERP
1. Historical
(+) Objectivity and simplicity
(+) Historical estimates will be unbiased if investors are rational
(-) Assumes that mean and variance of the returns are constant over time (that they are stationary). ERP is countercyclical
(-) Survivorship bias => upward biased ERP
2. Forward-looking
(+) Does not rely on the stationarity assumption
(+) Not subject to survivorship bias
3 categories of forward-looking estimates
Based on:
1. The Gordon growth model (constant growth model)
(-) forward-looking estimates will change through time and need to be updated
(-) stable growth rate is not appropriate for emerging markets
2. Supply-side models (macroeconomic models)
(+) the use of proven models and current information
(-) the estimates are only appropriate for developed countries
3. Estimates from surveys
GGM ERP =
!! Do not subtract risk-free rate if you want to find the required return!
Equity index price method to estimate ERP
Supply-side models
Ibbotson-Chen model
i = [1+YTM of 20-Y T-bonds]/[1+YTM of 20-Y TIPS] - 1
EGREPS = real GDP growth = labor productivity growth rate + labor supply growth rate
EGPE = 0 if the market is correctly priced, >0 if undervalued, <0 if overvalued
Survey estimates
They use the consensus of the opinions from a sample of people
(+) reliable results
(+) survey results are relatively easy to obtain
(-) disparity between consensuses from different groups
6 ways to estimate the required return on equity
CAPM
Fama-French model
Pastor-Stambaugh model
Macroeconomic multifactor models
Build-up method
Bond-yield plus risk premium
CAPM
r = rf + (ERP * β)
Fama-French
where
(Rsmall - Rbig) = small-cap return premium over large cap
(Rhbm - Rlbm) = value return premium over high P/B stocks
Pastor-Stambaugh
Adds a liquidity factor to the Fama French model
!!A positive liquidity beta is typical for small cap stocks (low liquidity)
Macroeconomic multifactor models
Burmeister, Roll and Ross model
5 factors of the Burmeister, Roll and Ross model
1. Confidence risk: unexpected change in the difference between the return of risky corporate bonds and government bonds
2. Time horizon risk: unexpected change in the difference between the return of long-term government bonds and T-bills
3. Inflation risk: unexpected change in the inflation rate
4. Business cycle risk: unexpected change in the level of real business activity
5. Market timing risk: the equity market return that is not explained by the other four factors
The factor values are multiplied by a sensitivity coefficient (beta)
The Build-up method
Good for closely held companies where betas are not readily obtainable
Required return = RF + EPR + size premium + specific-company premium
Bond-yield plus risk premium method
A buildup method appropriate if the company has publicly traded debt
Cost of equity = YTM + risk premium for holding the firm's equity
!!The bond yield is the company's yield, NOT the T-bond's
Beta drift
The observed tendency of an estimated beta to revert to a value of 1.0 over time
Adjusted beta for public companies =
(2/3 * regression beta) + (1/3)
Adjusted beta is closer to 1 than the regression beta
Estimate beta for thinly traded stocks
Unlever the beta of the benchmark company
Then lever it up
equity beta: beta before removing the effects of leverage
β'e: the subject company's equity beta
D', E': the subject company's debt and equity levels
4 steps to estimate beta for thinly traded stocks and nonpublic companies
Pros and cons of the models
CAPM
(+) very simple
(-) choose the appropriate factor
(-) a lot of market indexes if stock trades in more than 1 market
(-) low explanatory power
Multifactor
(+) high explanatory power
(-) more complex and expensive
Buildup
(+) simple
(+) good for closely-held companies
(-) they use historical values as estimates that may or may not be relevant to current market conditions
International considerations in required return estimation
1. Country Spread Model: adds a premium for the emerging market with a developed market as benchmark
2. Country Risk Rating Model: uses the ERP for developed countries as the dependent variable and risk ratings for those countries as the independent variable. Once the regression model is fitted, the model is then used for predicting the ERP for emerging markets risk-ratings
International considerations for estimating the required return
When estimating the required return on equities in a global context, analysts are concerned about various issues including:
Exchange rates
; and
Data and model issues in emerging markets
WACC =
;