Measuring Return

Fransisca Tharia Hartanto

Meeting 2 (Updated 2021)
Security Analysis
Source : Damodaran, Pinto

This material belongs to Universitas Prasetiya Mulya.

Slide|1
Do not share materials in public domain. For private use only!
Estimating the Required Return on
an Equity Investment
Multifactor Models
Capital Asset Pricing • Fama–French model
• Pastor–Stambaugh model
Model
• Macroeconomic models
• Statistical models

Build-Up Method

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|2
share materials in public domain. For private use only!
 Capital Asset Pricing Model
(CAPM)
RF + βi [ E ( RM ) − RF ],
E ( Ri ) =
• Where
• E(Ri) = Required return on equity for security i
• RF = Current expected risk-free return
• βi = Beta of security i
• E(RM) = Expected return on the market portfolio
• E(RM) – RF = Equity risk premium

• Assumptions
• Investors are risk averse
• Investment is based on mean–variance optimization
• Relevant risk is systematic risk

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|3
share materials in public domain. For private use only!
CAPM: Estimating Beta
• The standard procedure for estimating betas is to regress stock returns (Rj)
against market returns (Rm) -
Rj = a + b Rm
• where a is the intercept and b is the slope of the regression.
• The slope of the regression corresponds to the beta of the stock, and
measures the riskiness of the stock.
• This beta has three problems:
• It has high standard error
• It reflects the firm’s business mix over the period of the regression, not the current
mix
• It reflects the firm’s average financial leverage over the period rather than the
current leverage.
This material belongs to Universitas Prasetiya Mulya. Do not
Slide|4
share materials in public domain. For private use only!
 Beta Estimation Issues
Choice of Market • S&P 500 and NYSE Composite are common
Index choices in the United States

Length & • Five years of monthly data is most common

Frequency of Data choice

Adjusted Betas • Betas move towards 1.0 over time

Thinly Traded and • Adjust comparable betas for leverage

Private Firms

This material belongs to Universitas Prasetiya Mulya. Do not

5
share materials in public domain. For private use only!
Beta Estimation: The Index Effect
• This beta looks much better (in terms of
standard error) but it is misleading.
Nokia dominates the Helisinki index (it
was 70% of the index at the time of this
regression).
• The reason it is misleading is because
Nokia’s largest single investor at the
time was Barclays, which manages one
of the worlds’ largest global index funds.
Barclays would not view the beta of this
regression as a good measure of risk.
(They would probably prefer a beta
estimate against a global equity index
like the Morgan Stanley Capital Index).

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|6
share materials in public domain. For private use only!
 Solution to the Beta Regression Problem
• Modify the regression beta by
• changing the index used to estimate the beta
• adjusting the regression beta estimate, by bringing in information about the
fundamentals of the company
• Estimate the beta for the firm using
• the standard deviation in stock prices instead of a regression against an index
• accounting earnings or revenues, which are less noisy than market prices.
• Estimate the beta for the firm from the bottom up without employing
the regression technique. This will require
• understanding the business mix of the firm
• estimating the financial leverage of the firm

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|7
share materials in public domain. For private use only!
Determination of Betas

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|8
share materials in public domain. For private use only!
Step by Step of Adjusting Beta
Start with the beta of the business that the firm is in

Adjust the business beta for the operating leverage of the firm to arrive
at the unlevered beta for the firm

Use the financial leverage of the firm to estimate the equity beta for the firm
Levered Beta = Unlevered Beta * (1+(1 – tax rate)*(Debt/Equity)

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|9
share materials in public domain. For private use only!
 Adjusting for Operating Leverage
• Within any business, firms with lower fixed costs (as a percentage of
total costs) should have lower unlevered betas. If you can compute
fixed and variable costs for each firm in a sector, you can break down
the unlevered beta into business and operating leverage components.
• Unlevered beta = Pure business beta * (1 + (Fixed costs/ Variable costs))
• The biggest problem with doing this is informational. It is difficult to
get information on fixed and variable costs for individual firms.
• In practice, we tend to assume that the operating leverage of firms
within a business are similar and use the same unlevered beta for
every firm.
This material belongs to Universitas Prasetiya Mulya. Do not
Slide|10
share materials in public domain. For private use only!
 Adjusting for Financial Leverage
• Conventional approach: If we assume that debt carries no market risk (has
a beta of zero), the beta of equity alone can be written as a function of the
unlevered beta and the debt-equity ratio
βL = βu (1+ ((1-t)D/E))
In some versions, the tax effect is ignored and there is no (1-t) in the equation.
• Debt Adjusted Approach: If beta carries market risk and you can estimate
the beta of debt, you can estimate the levered beta as follows:
βL = βu (1+ ((1-t)D/E)) - βdebt (1-t) (D/E)
• While the latter is more realistic, estimating betas for debt can be difficult
to do.
This material belongs to Universitas Prasetiya Mulya. Do not
Slide|11
share materials in public domain. For private use only!
 Equity Risk Premium Estimates
• Historical Estimates

• Forward-Looking Estimates
• Gordon growth model estimates
• Macroeconomic model estimates
• Survey estimates

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|12
share materials in public domain. For private use only!
 Issues for Using Historical Equity
Risk Premium Estimates
• Length of Sample Period
• Balancing long-term and short-term considerations

• Geometric vs. Arithmetic Mean

• Geometric more accurately reflects future value

• Choice of Risk-Free Return

• On-the-run long-term Treasuries

• Survivorship Bias
• Using returns from surviving firms artificially inflates estimates of return

• Strings of Unusual Events

This material belongs to Universitas Prasetiya Mulya. Do not
Slide|13
share materials in public domain. For private use only!
Historical Equity Risk Premium Estimates
6
Number of Markets
4 4

1 1 1

1% to 2% 2% to 3% 3% to 4% 4% to 5% 5% to 6% 6% to 7%
Equity Risk Premiums

Equity premium puzzle : historical real returns of stocks is higher compare to

government bonds
This material belongs to Universitas Prasetiya Mulya. Do not
Slide|14
share materials in public domain. For private use only!
 Forward-Looking Equity
Risk Premium Estimates

Gordon
growth Dividend Earnings Government
model risk yield growth rate bond yield
premium

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|15
share materials in public domain. For private use only!
 Forward-Looking Equity
Risk Premium Estimates

Macroeconomic Model Equity Risk Premium (ERP) – Ibbotson & Chen (2003)
Supply side estimates based on top-down analysis
ERP = (1 + EINFL)(1 + EGREPS)(1 + EGPE) − 1 + EINC − RF

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|16
share materials in public domain. For private use only!
 Example:
Forward-Looking Equity Risk Premium
Yield on treasury bonds 3.8%
Yield on Treasury inflation-protected securities 1.8%
Expected growth in labor productivity 1.5%
Expected growth in labor supply 1.0%
Expected growth in the P/E 0.0%
Expected dividend yield 2.7%
Return from reinvestment of income 0.1%

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|17
share materials in public domain. For private use only!
 Example:
Forward-Looking Equity Risk Premium
1 + Treasury Bond Yield
Expected Inflation =
1 + TIPS Yield
1 + 0.038
=
Expected Inflation = − 1 2.0%
1 + 0.018

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|18
share materials in public domain. For private use only!
 Example:
Forward-Looking Equity Risk Premium
Real=
earnings growth Labor productivity + Labor supply growth
= 1.5% + 1.0%
= 2.5%

=
Expected income Dividend yield + Reinvestment return
= 2.7% + 0.1%
+2.8%

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|19
share materials in public domain. For private use only!
 Example:
Forward-Looking Equity Risk Premium

Macroeconomic model equity risk premium

=
ERP = (1 + EINFL)(1 + EGREPS)(1 + EGPE) − 1 + EINC − RF
=
(1 + 0.02)(1 + 0.025)(1 + 0) − 1.0 + 0.028 − 0.038
=
3.5%
This material belongs to Universitas Prasetiya Mulya. Do not
Slide|20
share materials in public domain. For private use only!
The Cost of Equity: A Recap

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|21
share materials in public domain. For private use only!
 Multifactor Models:
Fama–French Model
Market
Size
Risk
Premium
Premium

Risk-Free Value
Return Required Premium
Return
on Equity

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|22
share materials in public domain. For private use only!
 Fama–French Model
RF + βimkt RMRF + βsize
ri = i SMB + β value
i HML,
• where
• SMB = The return to small stocks minus the return to large stocks
• βsize = The sensitivity of security i to movements in small stocks
• HML = The return to value stocks minus the return to growth stocks
• β value = The sensitivity of security i to movements in value stocks

PASTOR–STAMBAUGH MODEL
RF + βimkt RMRF + βsize
ri = i SMB + β value
i HML + β i LIQ,
liq

• where
• LIQ = The return to illiquid stocks minus the return to liquid stocks
• β liq = The sensitivity of security i to movements in illiquid stocks

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|23
share materials in public domain. For private use only!
 Example:
Fama–French Model
Risk-free rate 3.0%
Equity risk premium 5.0%
Beta 1.20
Size premium 2.2%
Size beta 0.12
Value premium 3.8%
Value beta 0.34

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|24
share materials in public domain. For private use only!
 Example:
Fama–French Model
RF + β
ri = mkt
i RMRF + β SMB + β size
i
value
i HML
= 3% + 1.20(5%) + 0.12(2.2%) + 0.34(3.8%)
= 10.56%

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|25
share materials in public domain. For private use only!
Built Up Method
The formula for required return on share i =
Current expected risk-free rate + Equity risk premium ± Other risk premia (or
discounts) apppropriate for stock I

Notes :
• The formula does not make a beta adjustment to the equity risk premium but adds premia/discounts
required to develop an overall equity risk adjustment.
• Other risk premia factors are often based on factors such as size and perceived company-specific risk,
depending on the facts of the exercise and the valuator’s analysis of them.
• Size premium : Valuators often add a premium related to the excess returns of small stocks over large stocks,
reflecting an incremental return for small size. (The premium is typically after adjustment for the differences
in the betas of small- and large-cap stocks to isolate the effect of size—a beta-adjusted size premium.)
• Company specific premium : liquidity premium should be added for illiquid stocks – to consider the lack of
marketability
This material belongs to Universitas Prasetiya Mulya. Do not
26
share materials in public domain. For private use only!
Estimating the Cost of Debt
• The cost of debt is the rate at which you can borrow at currently. It will reflect not only your
default risk but also the level of interest rates in the market.
• If the company have mostly bank loan, you can search through the annual report for the
borrowing rate
• The two most widely used approaches to estimating cost of debt are:
1. Looking up the yield to maturity on a straight bond outstanding from the firm.
The limitation of this approach is that very few firms have long term straight bonds
that are liquid and widely traded
2. Looking up the rating for the firm and estimating a default spread based upon the
rating.
While this approach is more robust, different bonds from the same firm can have
different ratings. You have to use a median rating for the firm.

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|27
share materials in public domain. For private use only!
Dealing with Hybrids and Preferred Stock
• When dealing with hybrids (convertible bonds, for instance), break
the security down into debt and equity and allocate the amounts
accordingly. Thus, if a firm has $ 125 million in convertible debt
outstanding, break the $125 million into straight debt and conversion
option components. The conversion option is equity.
• When dealing with preferred stock, it is better to keep it as a separate
component. The cost of preferred stock is the preferred dividend
yield. (As a rule of thumb, if the preferred stock is less than 5% of the
outstanding market value of the firm, lumping it in with debt will
make no significant impact on your valuation).

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|28
share materials in public domain. For private use only!
 Weighted Average Cost of Capital

Weighted
Average
Cost of Capital

Debt Equity

Market Value Market Value

Cost of Debt Tax Rate Cost of Equity
of Debt of Equity

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|29
share materials in public domain. For private use only!
 Weighted Average Cost of Capital
MVD MVCE
rd (1 − Tax Rate) + re ,
MVD + MVCE MVD + MVCE

• Where
• MVD = Current market value of debt
• MVCE = Current market value of common equity
• rd = Before-tax cost of debt (which is transformed into the after-tax cost by
multiplying it by 1 – Tax rate)
• re = Cost of equity

This material belongs to Universitas Prasetiya Mulya. Do not

Slide|30
share materials in public domain. For private use only!
THANK YOU!! 

This material belongs to Universitas Prasetiya Mulya. Do not

31
share materials in public domain. For private use only!