R.27 Return Concepts

Question 1

HPR

Required Return

Expected Return

Equity Risk Premium

Answer 1

Question 2

Equity risk premium:

Beta estimates for Public vs non-public/thinly traded firms

Answer 2

Beta Estimation for a Public Company

• Simplest estimate is a regression of the returns of stock on the return on the market, which provides an unadjusted or “raw” historical beta. Actual beta values are influenced by several choices:
  
  • Index used to represent the market portfolio. For US equities, the S&P 500 and NYSE Composite have been traditional choices.
  • Length of data period and frequency of observations. Most common is 5-years of monthly data, yielding 60 observations.
• ​Adjusted beta = ²/₃ (Unadjusted beta) + ¹/₃ (1.0)
  
  • ​future period betas on average revert to a mean value of 1.0 so adjusted beta accounts for this.

Beta Estimation for Private, Thinly Traded Stocks and Nonpublic Companies

• Market price observations for nonpublic companies are unavailable for calculating a regression beat.
• So industry classification systems (GICS or ICB) are used to find peer companies to indirectly estimate beta of the nonpublic company.

Question 3

CAPM

ERP

Forward-looking ERP

Answer 3

Question 4

Return Concepts

How do you measure required return with:

• Multi-factor models:
  
  • Fama-French?
  • Pastor-Stambaugh?
• Build-up method
• Bond Yield plus Risk Premium method
• WACC

Answer 4

Question 5

Equity Risk Premium calcs

• GGM
• Macroeconomic model for ERP

Answer 5