Insights into Macro Hedge Funds

Survivorship bias Other statistical difficulties exist with historical risk premiums. According to one
argument,11 even properly measured historical premiums can’t predict future returns, because the
observable sample will include only countries with strong historical returns. Statisticians refer to this
phenomenon as survivorship bias. The U.S. market outperformed all others during the twentieth
century, averaging 4.3 percent in real terms (deflating by the wholesale price index) versus a
median of 0.8 percent for other countries.12 A concurring study13 notes that the −100 percent
returns from China, Russia, and Poland are too often ignored in discussions of stock market
performance. Since it is unlikely that the U.S. stock market will replicate its performance over the
next century, we adjust downward the historical arithmetic average market risk premium. Using data
from Philippe Jorion and William Goetzmann, we find that between 1926 and 1996, the U.S.
arithmetic annual return exceeded the median return on a set of 11 countries with continuous
histories dating to the 1920s by 1.9 percent in real terms, or 1.4 percent in nominal terms. If we
subtract a 1 percent to 2 percent survivorship bias from the long-term arithmetic average of 5.5
percent, the difference implies the future range of the U.S. market risk premium should be 3.5 to 4.5
percent. Market risk premium regressions Although we find no long-term trend in the historical risk
premium, many argue that the market risk premium is predictable using observable variables, such
as the aggregate dividend-toprice ratio, the aggregate book-to-market ratio, or the aggregate ratio
of earnings to price. The use of current financial ratios to estimate the expected return on stocks is
well documented and dates back to Charles Dow in the 1920s. The concept has been tested by many
authors.14 To predict the market risk premium using financial ratios, excess market returns are
regressed against a financial ratio, such as the market’s aggregate dividend-to-price ratio: R r ln m f −
=+ αβ ε + Dividend Price mcki_c10.qxd 5/25/05 8:39 AM Page 309 310 ESTIMATING THE
COST OF CAPITAL percent Exhibit 10.6 Expected Market Risk Premium Based on Dividend Yield
Source: Lewellen (2004), Goyal and Welch (2003), McKinsey analysis. 1955 1960 1965 1970 1975
1980 1985 1990 1995 2000 –5 –3 –1 0 5 7 9 1 3 2 4 –2 – 4 6 8 15 A. Goyal and I. Welch, “Predicting
the Equity Premium with Dividend Ratios,” Management Science, 4, 9(5) (2003): 639–654. Using
advanced regression techniques unavailable to earlier authors, Jonathan Lewellen found that
dividend yields do predict future market returns. But as shown in Exhibit 10.6, the model has a
major drawback: the risk premium prediction can be negative (as it was in the late 1990s). Other
authors question the explanatory power of financial ratios, arguing that a financial analyst relying
solely on data available at the time would have done better using unconditional historical averages
(as we did in the last section) in place of more sophisticated regression techniques.15 Forward-
looking models A stock’s price equals the present value of its dividends. Assuming dividends are
expected to grow at a constant rate, we can rearrange the growing perpetuity to solve for the
market’s expected return: In the previous section, we reviewed regression models that compare
market returns (ke ) to the dividend-price ratio (DIV/P). Using a simple reP k g k P g e = e − = + DIV
converts to DIV mcki_c10.qxd 5/25/05 8:39 AM Page 310 ESTIMATING THE COST OF EQUITY 311 16 J.
Claus and J. Thomas, “Equity Premia as Low as Three Percent? Evidence from Analysts’ Earnings
Forecasts for Domestic and International Stocks,” Journal of Finance, 56(5) (October 2001): 1629–
1666; and W. R. Gebhardt, C. M. C. Lee, and B. Swaminathan, “Toward an Implied Cost of Capital,”
Journal of Accounting Research, 39(1) (2001): 135–176. 17 Eugene F. Fama and Kenneth R. French,
“The Equity Premium,” Center for Research in Security Prices Working Paper No. 522 (April 2001).
18 Marc H. Goedhart, Timothy M. Koller, and Zane D. Williams, “The Real Cost of Equity,” McKinsey
on Finance (Autumn 2002): 11–15. 19 Using a two-stage model (i.e., short-term ROE and growth rate
projections, followed by longterm estimates) did not change the results in a meaningful way.
gression, however, ignores valuable information and oversimplifies a few market realities. First, the
dividend-price yield itself depends on the expected growth in dividends (g), which simple
regressions ignore (the regression’s intercept is determined by the data). Second, dividends are only
one form of corporate payout. Companies can use free cash flow to repurchase shares or hold
excess cash for significant periods of time; consider Microsoft, which accumulated more than $50
billion in liquid securities before paying its first dividend. Using the principles of discounted cash flow,
along with estimates of growth, various authors have attempted to reverse engineer the market risk
premium. Two studies used analyst forecasts to estimate growth,16 but many argue that analyst
forecasts focus on the short term and are severely upward biased. Fama and French use long-term
dividend growth rates as a proxy for future growth, but they focus on dividend yields, not on
available cash flow.17 Alternatively, our own research has focused on all cash flow available to equity
holders, as measured by a modified version of the key value driver formula (detailed in Chapter 3):18
Based on this formula, we used the long-run return on equity (13 percent) and the long-run growth
in real GDP (3.5 percent) to convert a given year’s S&P 500 median earnings-to-price ratio into the
cost of equity.19 Exhibit 10.7 on page 312 plots the nominal and real expected market returns
between 1962 and 2002. The results are striking. After stripping out inflation, the expected market
return (not excess return) is remarkably constant, averaging 7.0 percent. For the United Kingdom, the
real market return is slightly more volatile, averaging 6.0 percent. Based on these results, we
estimate the current market risk premium by subtracting the current real long-term risk-free rate
from the real equity return of 7.0 percent (for U.S. markets). At year-end 2003, the yield on a U.S.
Treasury inflation-protected security (TIPS) equaled 2.1 percent. Subtracting 2.1 k g P g e e = −
+ = Earnings 1 ROE such that CF Earnings 1 ROE − g mcki_c10.qxd 5/25/05 8:39 AM
Page 311 312 ESTIMATING THE COST OF CAPITAL percent Exhibit 10.7 Real and Nominal Expected
Market Returns 0 5 10 15 20 1962 1972 1982 1992 2002 Nominal expected return Real expected
return percent from 7.0 percent gives an estimate of the risk premium at just under 5 percent.
Although many in the finance profession disagree about how to measure the market risk premium,
we believe 4.5 to 5.5 percent is an appropriate range. Historical estimates found in most textbooks
(and locked in the mind of many), which often report numbers near 8 percent, are too high for
valuation purposes because they compare the market risk premium versus short-term bonds, use
only 75 years of data, and are biased by the historical strength of the U.S. market. Estimating beta
According to the CAPM, a stock’s expected return is driven by beta, which measures how much the
stock and market move together. Since beta cannot be observed directly, we must estimate its
value. To do this, we first measure a raw beta using regression and then improve the estimate by
using industry comparables and smoothing techniques. The most common regression used to
estimate a company’s raw beta is the market model: In the market model, the stock’s return (not
price) is regressed against the market’s return. In Exhibit 10.8, we plot 60 months of Home Depot
stock returns versus S&P 500 returns between 1999 and 2003. The solid line represents the “best R R
i m =+ + αβ ε mcki_c10.qxd 5/25/05 8:39 AM Page 312 ESTIMATING THE COST OF EQUITY 313
percent Exhibit 10.8 Home Depot: Stock Returns versus S&P 500 Returns, 1999–2003 –25 –15 –5 0 5
15 25 –25 –15 –5 5 15 25 S&P 500 monthly returns Home Depot monthly stock returns Beta = 1.37 R²
= 0.43 fit” relation between Home Depot’s stock returns and the stock market. The slope of this line
is commonly denoted as beta. For Home Depot, the company’s raw beta (slope) is 1.37. Since typical
betas range between 0 and 2, with the value-weighted average beta equaling 1, this raw result
implies Home Depot is riskier than the typical stock. But why did we choose to measure Home
Depot’s returns in months? Why did we use five years of data? And how precise is this
measurement? The CAPM is a one-period model and provides little guidance on implementation.
Yet, based on certain market characteristics and a variety of empirical tests, we reach several
conclusions: • Raw regressions should use at least 60 data points (e.g., five years of monthly returns).
Rolling betas should be graphed to examine any systematic changes in a stock’s risk. mcki_c10.qxd
5/25/05 8:39 AM Page 313 314 ESTIMATING THE COST OF CAPITAL 20 F. Black, M. Jensen, and M.
Scholes, “The Capital Asset Pricing Model: Some Empirical Tests,” in Studies in Theory of Capital
Markets, ed. M. Jensen (New York: Praeger, 1972). 21 Alexander and Chervany tested the accuracy of
estimation periods from one to nine years. They found four-year and six-year estimation periods
performed best but were statistically indistinguishable. G. Alexander and N. Chervany, “On the
Estimation and Stability of Beta,” Journal of Financial and Quantitative Analysis, 15 (1980): 123–137.
• Raw regressions should be based on monthly returns. Using shorter return periods, such as daily
and weekly returns, leads to systematic biases. • Company stock returns should be regressed
against a valueweighted, well-diversified portfolio, such as the S&P 500 or MSCI World Index. Next,
recalling that raw regressions provide only estimates of a company’s true beta, we improve
estimates of a company’s beta by deriving an unlevered industry beta and then relevering the
industry beta to the company’s target capital structure. If no direct competitors exist, you should
adjust raw company betas by using a smoothing technique. We describe the basis for our conclusions
next. Measurement period Although there is no common standard for the appropriate
measurement period, we follow the practice of data providers such as Standard & Poor’s and Value
Line, which use five years of monthly data to determine beta. Using five years of monthly data
originated as a rule of thumb during early tests of the CAPM.20 In subsequent tests of optimal
measurement periods, researchers confirmed five years as appropriate.21 Not every data provider
uses five years. The data service Bloomberg, for instance, creates raw betas using two years of
weekly data. Because estimates of beta are imprecise, however, plot the company’s rolling 60-month
beta to visually inspect for structural changes or shortterm deviations. For instance, changes in
corporate strategy or capital structure often lead to changes in risk for stockholders. In this case, a
long estimation period would place too much weight on stale data. In Exhibit 10.9, we graph IBM’s
raw beta between 1985 and 2004. As the exhibit shows, IBM’s beta hovered near 0.7 in the 1980s
but rose dramatically in the mid-1990s and now measures near 1.3. This rise in beta occurred
during a period of great change for IBM, as the company moved from hardware (such as mainframes)
to services (such as consulting). Subsequently, using a long estimation period (for instance, 10
years) would underestimate the risk of the company’s new business model. Frequency of
measurement In 1980, Nobel laureate Robert Merton argued that estimates of covariance, and
subsequently beta, improve as returns are mcki_c10.qxd 5/25/05 8:39 AM Page 314 ESTIMATING
THE COST OF EQUITY 315 Exhibit 10.9 IBM: Market Beta, 1985–2004 0.0 0.4 0.8 1.2 1.6 1985 1988
1991 1994 1997 2000 2003 Beta 22 R. Merton, “On Estimating the Expected Return on the Market,”
Journal of Financial Economics, 8 (1980): 323–361. 23 M. Scholes and J. T. Williams, “Estimating
Betas from Nonsynchronous Data,” Journal of Financial Economics, 5 (1977): 309–327. See also E.
Dimson, “Risk Measurement When Shares Are Subject to Infrequent Trading,” Journal of Financial
Economics, 7 (1979): 197–226. measured more frequently.22 Implementing Merton’s theory,
however, has proven elusive. Empirical problems make high-frequency beta estimation unreliable.
Therefore, we recommend using monthly data. Using daily or even weekly returns is especially
problematic when the stock is rarely traded. An illiquid stock will have many reported returns equal
to zero, not because the stock’s value is constant but because it hasn’t traded (only the last trade is
recorded). Consequently, estimates of beta on illiquid stocks are biased downward. Using longer-
dated returns, such as monthly returns, lessens this effect. One proposal for stocks that trade
infrequently even on a monthly basis is to sum lagged betas.23 In lagged-beta models, a stock’s
return is simultaneously regressed on concurrent market returns and market returns from the prior
period. The two betas from the regression are then summed. A second problem with using high-
frequency data is the bid/ask bounce. Periodic stock prices are recorded at the last trade, and the
recorded price depends on whether the last trade was a purchase (using the ask price) or a sale
(using the bid price). A stock whose intrinsic value remains unchanged will therefore “bounce”
between the bid and ask price, causing distortions in beta estimation. Using longer-period returns
dampens this distortion