Valuation & The Equity Risk Premium
Valuation & the equity risk premium
Author: Joris Kersten MSc/ Owner Kersten Corporate Finance
Kersten Corporate Finance: M&A advisory + Business Valuations + Valuation Training
Source used: Morgan Stanley Investment Management, Counterpoint Global Insights: Cost of Capital – A practical guide to measuring opportunity cost. 2023. M.J. Mauboussin & D. Callahan.
Introduction
In this blog series I will talk about the cost of capital for valuation.
This is the 2nd article in this sequence, and the 1st one was about “the cost of debt” (23rd June 2023).
In case you have not read it yet, you can find it on the link below:
Cost of equity model
The cost of equity is the expected total return on a company’s stock.
The cost of equity is higher than the cost of debt since equity is a junior claim on the value of the firm.
We can not observe the cost of equity directly, so we need an asset pricing model.
The best known model is the “capital asset pricing model” (CAPM).
Financial executives rely on CAPM, but in the investment community (quantitative funds) models with more variables are used.
Let’s now look at CAPM since this is the model most practitioners use.
CAPM
The CAPM estimates the expected return of a security by multiplying the equity risk premium (ERP) with the security’s Beta.
And the risk free rate (RFR) is added on top.
The ERP equals the difference between the expected return for the market and the RFR.
Think about it as a “credit spread”.
The ERP is the same for all stocks in the CAPM because it captures what is known as “systematic risk”.
This means risk that can not be diversified away.
And Beta measures how a company’s risk contributes to the portfolio risk.
And this is “unsystematic risk” and can be reduced through portfolio diversification.
Risk free rate & equity risk premium
A proxy for the risk free rate is a yield on a long term default free government fixed income security.
The yield on the 10 year US treasury note is suitable for businesses in the US.
The ERP is the difference between the return on the equity market and the return of the risk free asset.
Surveys show that ERP estimates are in a range from 3% to 10%.
Other insights provide an estimate range from 0 to 7% with an average of about 4%.
(check the article I have used as a source for this blog for full details, find this source below, or above, this blog)
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Equity risk premium estimates
There are 3 common approaches to estimate the ERP:
1.??????One can look at historical results and assume the future will be similar to the past;
2.??????One can survey investors about their expectations;
3.??????One can estimate a rate the market implies by reverse engineering assumptions.
Historical results are supported by lots of data but are heavily influenced by time period selection, and they include “survivorship bias”, and they are different when using “arithmetic” or “geometric” averages.
Expectations by experts provide snapshots of attitudes at a specific moment.
And an ERP implied by the market uses current prices, but requires forecasts for drivers such as cash flow growth and return on capital.
Historical ERP
For valuation ERP’s are needed that look forward, but it is still helpful to study the past for historical averages.
To study the past judgement is needed for:
1.??????Which RFR to use;
2.??????Time period to use;
3.??????Arithmetic or geometric returns.
Damodaran finds that the historical ERP falls in the range of 3 % to 12 % depending on how is measured.
For equity less bond returns in the US from 1928 – 2022 the arithmetic return was 6,6 % and the geometric return was 5,1 %.
ERP by market prices
One can also estimate the ERP by market prices.
The idea is that the key drivers of value, including earnings & dividends, follow long term trends that are predictable to some extent.
By estimating future cash flows, and knowing the current price, it is possible to solve for the “discount rate”.
When looking at august 2008 to 2022, Damodaran used the 10 year treasury note as the risk free rate and estimated the ERP.
The average ERP over this period was 5,5% with a high of 7,7% and a low of 3,9%.
Expected return (RFR + ERP) ranged from 10,7% and 5,1% in this time period.
These numbers are not adjusted for inflation.
Damodaran on the ERP: Overall insights
Aswath Damodaran posts an updated estimate of the risk premium on his website every month.
He has annual estimates for the ERP from 1961.
The range goes from 2,1 % to 6,5 %.
These estimates are not adjusted for inflation.
Thanks for reading,
My next blog in this sequence will be about “betas”,
Best regards Joris??
Source used: Morgan Stanley Investment Management, Counterpoint Global Insights: Cost of Capital – A practical guide to measuring opportunity cost. 2023. M.J. Mauboussin & D. Callahan.