Corporate Valuation

Session 5

Shobhit Aggarwal
16 July 2021
IIM Udaipur
Market Risk Premiums
 Forward looking Risk Premiums

• If GoI promises you guaranteed 10 Rs. Per year in

perpetuity, how much will you pay them for this
perpetuity?
• Ans. 10/risk-free rate
 Forward looking Risk Premiums

• If the payment is not guaranteed but as risky as

the average stock market, then how much will
you pay?
• Ans. The answer here determines the implicit
forward looking return expectation from the
market. Reduce the risk-free rate and you have
the expected risk premium. Thus, to calculate
forward looking risk premiums, look at what the
market is paying on average and calculate an IRR
on expected cash flows in future
Implied Risk Premium for NIFTY
 Implied Risk Premium for Market Index

• Use analyst estimate of growth not because it is

right but because it is what the markets expect
and we are trying to estimate what the market
expects as returns on average
Forward Looking Market Risk Premium
• Example of Forward Looking market risk
premium
– Colgate Palmolive
 Question 1
• What is implied expected risk premium?
―Answer: It is the market’s expected return
based on the current index price and the
expected cash flows (back-calculated IRR)
 Question 2

• Question 2: What happens to equity risk

premium when Index goes up by 10%?
―Answer: ERP goes down since higher price
means, you as an investor are fine with lower
returns
 Question 3

• Question 3: What happens to ERP if the index

is unchanged and the cash flows go up by
10%?
―Answer: ERP goes up as you are getting higher
cash flows for similar price, you get more
returns (in this case you demand more
returns)
 Question 4

• Question 4: What happens to ERP if both the

market and the cash flows go up by 10%?
―Answer: Nothing. Both numerator and
denominator go up by same ratio, the answer
remains unchanged
 Question 5

• Question 5: What happens to ERP if the

expected growth for the next 5 years goes up?
―Answer: ERP goes up since again cash flows go up
while price remains same
 Question 6

• Question 6: What happens to ERP if the risk-

free rate goes up?
― Answer: ERP goes down. It has not come down as
much as risk-free rate goes up since when risk-free
rates go up, so does the expected growth
• This last example shows that interest rates
going up does not always mean that stock
prices will come down or vice versa. Economic
health is the common cause for both interest
rates and stock prices e.g. interest rates in the
world collapsed in 2008, but so did the stock
markets
• Can we assume the ERP to be approximately constant
every year?

―Not really since market value of Index and risk-free rate keeps
changing continuously. When the market changes significantly, so
does the risk premium

―DO NOT adjust the market risk premiums to reflect ‘normalized’ or

‘reasonable’ risk premiums. Reasonable is what the market
expects. Not what we(as individuals) expect.
 Question 7
• What must happen when equity risk premium is
too high? Should you as an investor invest in
equities or bonds? Should the CFO of a company
raise money through bonds or equities?
―Answer: Too high a premium means too low a
price. It is a great time to invest in equities. It also
implies that CFOs must raise money through
bonds and not equities.
 Concept Checker 1

• If you use a market risk premium of 4% in this

market, what would you find for most of the
stocks?
a) Most stocks are over-valued
b) Most stocks are under-valued
c) It will not matter as long you use the same premium
for all stocks
• Why?
– Because you are assuming that the market itself is
under-valued
 Concept Checker 2
• If the implied premiums are lower than historical
premiums and you use historical premiums to value
firms, you will find:-
a) Growth stocks as more lucrative compared to
value stocks
b) Value stocks are more lucrative to growth stocks
c) Both kinds of stocks as equally lucrative
― Answer : Value stocks as more lucrative to growth
stocks
 Cheap stocks during recession?
• When a recession hits a market (maybe due to
a crisis), stocks start to fall. Is that a good time
to buy stocks which did not have their cash-
flows impacted?
– Not necessarily. When a crisis hits a stock market,
stocks fall because market risk premiums go up for
all companies (both which were hit directly and
the ones which were not). Hence, even though
cash-flows do not change, fair values may fall
 Estimating country risk-premiums

• Method 1: The default spread for the

country’s bonds is the country risk premium
• India Default Spread = 2.15%
• India Country Risk premium = 2.15%
 Estimating country risk-premiums

• Method 2: Multiply the mature market risk

premium with a ratio of standard deviations of
equity returns from the benchmark indices of the
two countries (numerator will be the country
whose risk premium is being estimated). This
directly gives the total equity risk premium and not
the country risk premium.
– The problem with this approach is that it cannot be used
for illiquid markets since then the prices are stale and
the standard deviations are artificially low resulting in
under-estimation of equity risk premiums
 Estimating country risk-premiums

• Method 2 example

US Risk Premium = 5.75%

Sensex 10 yr volatility = 24.06%
NYSE Composite 10 yr daily volatility = 21.92%
India Risk Premium = 5.75%*24.06%/21.92%=
6.311%
India Country Risk Premium = 6.375% - 5.75% =
0.561%
 Estimating country risk-premiums

• Method 3: Multiply the default spread for the

country’s bonds over the bonds of a mature
market with the ratio of standard deviations of
its equity markets to the standard deviations of
its bonds markets. This assumes that the liquidity
is similar in equity and bond markets of a country
– Another problem with this measure is that there might
be exceptional countries which have no default risk
estimate (since they have no bonds) but they may
have a reasonable equity risk. This method assigns
them a zero country risk
 Estimating country risk-premiums

• Method 3 example

Sensex 10 yr volatility = 24.06%

India Bond 10 yr volatility = 6.79%
India Country Risk Premium =
2.15%*24.06%/6.79%= 7.62%
 Multi-national companies

• If a company tells you revenues by region rather

than by country, then to arrive at regional risk
premiums, calculate a weighted average with
national GDP being the weights
 How to use country risk-premiums in CAPM

• Method 1: CRP is also multiplied by beta. It

assumes that the company is exposed to country
risk to the extent that it is exposed to economic
risk of the market
–]
• Method 2: Use a different beta coefficient
for country risk (e.g. proportion of revenues
from a country) and a different one for
market risk
 Country Risk Premium and Lambda
• Example of Country Risk Premium and Lambda
– FMN Nigeria
– Bharti Airtel
– Colgate Palmolive