Equity Asset Valuation Workbook
Equity Asset Valuation Workbook
After completing this chapter, you will be able to do the following:
distinguish among realized holding period return, expected holding period return, required return, return from convergence of price to intrinsic value, discount rate, and internal rate of return;
calculate and interpret an equity risk premium using historical and forward-looking estimation approaches;
estimate the required return on an equity investment using the capital asset pricing model, the Fama-French model, the Pastor-Stambaugh model, macroeconomic multifactor models, and the build-up method (e.g., bond yield plus risk premium);
explain beta estimation for public companies, thinly traded public companies, and nonpublic companies;
describe strengths and weaknesses of methods used to estimate the required return on an equity investment;
explain international considerations in required return estimation;
explain and calculate the weighted average cost of capital for a company;
evaluate the appropriateness of using a particular rate of return as a discount rate, given a description of the cash flow to be discounted and other relevant facts. SUMMARY OVERVIEW
In this reading we introduced several important return concepts. Required returns are important because they are used as discount rates in determining the present value of expected future cash flows. When an investor's intrinsic value estimate for an asset differs from its market price, the investor generally expects to earn the required return plus a return from the convergence of price to value. When an asset's intrinsic value equals price, however, the investor only expects to earn the required return.
For two important approaches to estimating a company's required return, the CAPM and the build-up model, the analyst needs an estimate of the equity risk premium. This reading examined realized equity risk premia for a group of major world equity markets and also explained forward-looking estimation methods. For determining the required return on equity, the analyst may choose from the CAPM and various multifactor models such as the Fama-French model and its extensions, examining regression fit statistics to assess the reliability of these methods. For private companies, the analyst can adapt public equity valuation models for required return using public company comparables, or use a build-up model, which starts with the risk-free rate and the estimated equity risk premium and adds additional appropriate risk premia.
When the analyst approaches the valuation of equity indirectly, by first valuing the total firm as the present value of expected future cash flows to all sources of capital, the appropriate discount rate is a weighted average cost of capital based on all sources of capital. Discount rates must be on a nominal (real) basis if cash flows are on a nominal (real) basis.
Among the reading's major points are the following:
The return from investing in an asset over a specified time period is called the holding period return . Realized return refers to a return achieved in the past, and expected return refers to an anticipated return over a future time period. A required return is the minimum level of expected return that an investor requires to invest in the asset over a specified time period, given the asset's riskiness. The ( market ) required return , a required rate of return on an asset that is inferred using market prices or returns, is typically used as the discount rate in finding the present values of expected future cash flows. If an asset is perceived (is not perceived) as fairly priced in the marketplace, the required return should (should not) equal the investor's expected return. When an