HURDLE

RATES III: ESTIMATING

EQUITY RISK PREMIUMS PART I
Stocks are risky! Really!
 Set Up and Objective
1: What is corporate finance
2: The Objective: Utopia and Let Down
3: The Objective: Reality and Reaction

The Investment Decision The Financing Decision The Dividend Decision

Invest in assets that earn a return Find the right kind of debt for your If you cannot find investments that make
greater than the minimum acceptable firm and the right mix of debt and your minimum acceptable rate, return the
hurdle rate equity to fund your operations cash to owners of your business

Hurdle Rate
Financing Mix
4. Define & Measure Risk 17. The Trade off Dividend Policy
5. The Risk free Rate 18. Cost of Capital Approach 24. Trends & Measures
6. Equity Risk Premiums 19. Cost of Capital: Follow up 25. The trade off
7. Country Risk Premiums 20. Cost of Capital: Wrap up 26. Assessment
8. Regression Betas 21. Alternative Approaches 27. Action & Follow up
9. Beta Fundamentals 22. Moving to the optimal 28. The End Game
10. Bottom-up Betas
11. The "Right" Beta
Financing Type
12. Debt: Measure & Cost
23. The Right Financing Valuation
13. Financing Weights
29. First steps
30. Cash flows
Investment Return 31. Growth
14. Earnings and Cash flows 32. Terminal Value
15. Time Weighting Cash flows 33. To value per share
16. Loose Ends 34. The value of control
35. Relative Valuation

36. Closing Thoughts

The Equity Risk Premium

The risk premium is the premium that investors

demand for invesIng in an average risk investment,
relaIve to the riskfree rate.
As a general proposiIon, this premium should be

greater than zero

increase with the risk aversion of the investors in that

market
increase with the riskiness of the average risk
investment

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What is your risk premium?

Assume that stocks are the only risky assets and that you are
oered two investment opIons:
a riskless investment (say a Government Security), on which you can
make 3%
a mutual fund of all stocks, on which the returns are uncertain
How much of an expected return would you demand to shiX
your money from the riskless asset to the mutual fund?
a. Less than 3%
b. Between 3 - 5%
c. Between 5 - 7%
d. Between 7 -9%
e. Between 9%- 11%
f. More than 11%

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Risk Premiums do change..

Go back to the previous example. Assume now that

you are making the same choice but that you are
making it in the aXermath of a stock market crash (it
has dropped 25% in the last month). Would you
change your answer?
a. I would demand a larger premium
b. I would demand a smaller premium
c. I would demand the same premium

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EsImaIng Risk Premiums in PracIce

Survey investors on their desired risk premiums and

use the average premium from these surveys.
Assume that the actual premium delivered over long
Ime periods is equal to the expected premium - i.e.,
use historical data
EsImate the implied premium in todays asset
prices.

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A. The Survey Approach

Surveying all investors in a market place is impracIcal.

However, you can survey a few individuals and use these results. In
pracIce, this translates into surveys of the following:

The limitaIons of this approach are:

there are no constraints on reasonability (the survey could produce
negaIve risk premiums or risk premiums of 50%)
The survey results are extremely volaIle
they tend to be short term; even the longest surveys do not go beyond
one year.

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B. The Historical Risk Premium
United States January 2014
" Arithmetic Average" Geometric Average"
" Stocks - T. Bills" Stocks - T. Bonds" Stocks - T. Bills" Stocks - T. Bonds"
1928-2013" 7.93%" 6.29%" 6.02%" 4.62%"
Std Error" 2.19%! 2.34%! " "
1964-2013" 6.18%" 4.32%" 4.83%" 3.33%"
Std Error" 2.42%! 2.75%! " "
2004-2013" 7.55%" 4.41%" 5.80%" 3.07%"
What is the right
Std Error" p remium?
6.02%! 8.66%! " "
1. Go back as far as you can. Otherwise, the standard error in the esImate will be
large.

2. Be consistent
Stdin your inuse
Error of a riskfree
estimate = rate.
Annualized Std deviation in Stock prices
)
3. Use arithmeIc premiums for one-year esImates Number ooff cyears
osts oof
f ehistorical
quity and data
geometric
premiums for esImates of long term costs of equity.

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What about historical premiums for other markets?

Historical data for markets outside the United States is

available for much shorter Ime periods. The problem is even
greater in emerging markets.
The historical premiums that emerge from this data reects
this data problem and there is much greater error associated
with the esImates of the premiums.
Put simply, if you distrust historical risk premiums in the
United States, because the esImates are backward looking
and noisy, you will trust them even less outside the US,
where you have less data.

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One soluIon: Bond default spreads as CRP
November 2013

In November 2013, the historical risk premium for the US was 4.20% (geometric
average, stocks over T.Bonds, 1928-2012)

" Arithmetic Average" Geometric Average"

" Stocks - T. Bills" Stocks - T. Bonds" Stocks - T. Bills" Stocks - T. Bonds"
1928-2012" 7.65%" 5.88%" 5.74%" 4.20%"
Using the "default spread 2.20%"
on the sovereign
2.33%" b ond o r b ased
" u pon t he sovereign
"
raIng and adding that spread to the mature market premium (4.20% for the US):


Country RaIng Default Spread (Country Risk Premium) US ERP Total ERP for country
If you prefer CDS spreads:
India Baa3 2.25% 4.20% 6.45%
China Aa3 0.80% 4.20% 5.00%
Brazil Baa2 2.00% 4.20% 6.20%

Country
India
Sovereign CDS Spread
4.20%
US ERP Total ERP for country
4.20% 8.40%
China 1.20% 4.20% 5.40%
Brazil 2.59% 4.20% 6.79%
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Beyond the default spread? EquiIes are riskier
than bonds
While default risk spreads and equity risk premiums are highly correlated, one would expect
equity spreads to be higher than debt spreads. One approach to scaling up the premium is
to look at the relaIve volaIlity of equiIes to bonds and to scale up the default spread to
reect this:

Brazil: The annualized standard deviaIon in the Brazilian equity index over the previous year
is 21 percent, whereas the annualized standard deviaIon in the Brazilian C-bond is 14
percent.

Using the same approach for India and China:
! 21% $
Brazil's Total Risk Premium = 4.20% + 2.00%# & = 7.20%
" 14% %

! 24% $
Equity Risk PremiumIndia = 4.20% + 2.25%# & = 7.80%
" 17% %
! 18% $
Equity Risk PremiumChina = 4.20% + 0.80%# & = 5.64%
" 10% %

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 Task Read
EsImate the Chapter 4
historical
equity risk
premium in
the market of
your choice
(if you can)

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