Dissecting Risk Premiums


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A presentation given to the DC Chapter of the American Society of Appraisers on the current challenges of calculating the cost of equity capital.

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Dissecting Risk Premiums

  1. 1. DISSECTING RISK PREMIUMSAmerican Society of AppraisersWashington, DC, Metro Area ChapterPresented: March 14, 2012Zachary C. Reichenbach, CPAMichael B. Lawrence
  2. 2. Overview• Introduction to the Cost of Equity• Introduction of Risk Premium• Ibbotson‟s Historical ERP• Ibbotson‟s Supply Side ERP• Duff & Phelps‟ ERP• Current Economic Challenges• Adjustments to ERP• Adjustments to Risk Free Rate• Use of Monthly ERP Data – Damadoran Online• Conclusion/Questions
  3. 3. Introduction to the Cost of Equity• Definition: The return a company theoretically pays to its equity investors to compensate for the risk they undertake by investing their capital• Measures and Quantifies Risk • Market Risk • Size Risk • Industry Risk • Specific Company Risk• Used to determine the WACC • Two Components: Debt and Equity• Primarily used for Income Approach methods of valuation
  4. 4. Cost of Equity (cont.)• Two Methods to Calculate the Cost of Equity• Both Methods Quantify Risk – “Building Blocks” Build Up Method Modified CAPM Risk Free Rate Risk Free Rate Equity Risk Premium (β x ERP) Size Premium Size Premium Specific Company Risk Industry Risk Premium Premium Specific Company Risk Premium
  5. 5. Introduction to Risk Premium• What is a Risk Premium? • The return in excess of the risk-free rate of return that an investment is expected to yield • Gives investors incentives to invest in riskier securities • The unknown – the possibility that an investor might lose his initial investment Example:20-Year U.S. Difference in Yield = RP GE StockTreasury Bond Yield: 4% RP = 11% Yield: 15%
  6. 6. Risk Premiums on Various SecuritiesSecurity Risk PremiumsTreasury Bills Real Rate + InflationTreasury Notes Real Rate + Inflation + Duration PremiumTreasury Bonds Real Rate + Inflation + Duration PremiumCorporate Bonds Real Rate + Inflation + Duration Premium + Default PremiumLarge Cap Stocks Real Rate + Inflation + Equity Risk PremiumSmall Cap Stocks Real Rate + Inflation + Equity Risk Premium + Size Premium
  7. 7. Ibbotson‟s ERP Data
  8. 8. Ibbotson• Calculating the Historical ERP • Stock Market Benchmark • Risk-Free Asset • Arithmetic or Geometric Average • Time Period for Measurement
  9. 9. Ibbotson – Stock Market Benchmark• Broad index that reflects the market as a whole • S&P 500 • New York Stock Exchange Composite Index• Dow Jones Industrial Average – inappropriate for calculating ERP • Too narrow• Total return of large company stock index as the market benchmark • S&P 500 – large sample of companies over a large number of industries • 88 separate industry groups since December 31, 1993 • Most widely accepted
  10. 10. Ibbotson – Market Benchmark and Firm Size• Valuation professionals usually value small companies • Have different risk and return characteristics than large companies • Adjustment if using large stock index to account for differences • Based on size premium • Smaller companies have higher returns on average than larger ones • Less liquid, higher cost of capital requires higher return • Liquidity not directly observable • Capitalization is measurable size can serve as a partial measure of cost of capital
  11. 11. Ibbotson – Risk-Free Asset• Short-Term Horizon 30-day Treasury Bill• Intermediate-Term Horizon 5-year Treasury Bond• Long-Term Horizon 20-year Treasury Bond• Long-horizon equity risk premium is preferable for use in most business-valuation settings • Even if investor has a shorter time horizon • Companies are entities that generally have no defined life span • Important to use long-term discount rate; life of company infinite• 20-Year versus 30-Year Treasuries • 30-Year securities have only been issued over the recent past („77)
  12. 12. Ibbotson – Arithmetic versus Geometric Means• Ibbotson utilizes arithmetic average risk premia • Appropriate when discounting future cash flows • The equity risk premium that should be employed is the equity risk premium expected to be incurred over future time periods • Applicable for CAPM or Build-Up Method • Both CAPM and Build-Up Method are additive models • Cost of capital is the sum of its parts • Simple difference between arithmetic means of stock market returns and riskless rates• Geometric mean more appropriate for reporting past performance • Represents compound average return
  13. 13. Ibbotson – Appropriate Historical Time Period• ERP can be estimated using any historical time period • U.S. market data exists back to the late 1800s • Ibbotson covers the time period from 1926 to present • Original data source for the time series – Center for Research in Security Prices (CRSP) • Begins their analysis of market returns with 1926 for 2 reasons: 1. CRSP determined that the time period around 1926 was when quality financial data became available • Wanted to include extreme market volatility from the late twenties and early thirties 2. 1926 includes one full business cycle before the market crash of 1929• Implicit in using history to forecast future, investors‟ expectations for future outcomes conform to past results • “Future equals the past” assumption
  14. 14. Ibbotson – Appropriate Historical Time Period• Prediction of economic environment of future• Does the period account for too many “unusual” events? • All periods contain unusual events • Inflation of late 1970s • October 1987 stock market crash • Collapse of the high-yield bond market • Major contraction of the thrift industry • Collapse of the Soviet Union • Development of the European Economic Community • Attacks of September 11, 2001 • Liquidity crisis of 2008 • Long-term time period will smooth out volatility from certain market conditions
  15. 15. Ibbotson – ERP Represent Minority orControlling Interest?• Use of publicly traded company data to derive equity risk premium – Is a minority discount implicit in this data? • Both the S&P 500 and the NYSE include a preponderance of companies that are minority held • Does the Equity risk premium (or size premium) derived from this data represent a minority interest premium? • Application of a minority discount or control premium can have a material impact on the indication of value – watch for “double dipping” • Not correct to assume the risk premia derived from these return data have a minority discount implicit within them • Returns generated by the S&P 500 and the NYSE represent returns to equity holders • The ERP represents expected premiums that holders of securities of a similar nature can expect to achieve on average in the future • No distinction between minority owners and controlling owners • Adjust cash flows, not discount rate
  16. 16. Issues with Ibbotson‟s Historical ERP• Survivorship • Premise: U.S. stock market is most successful stock market in 20th Century • Potential overstatement of ERP due to a higher-than-average stock market • Global capital markets have been systematically subject to dramatic changes over the past century; the U.S. is the exception as it has not been subject to dramatic changes • Pollutes U.S. markets with more “winners” with “losers” • U.S. real capital appreciation since 1926 is 4.3 percent • Global capital markets average capital appreciation since 1926 is 0.8 percent
  17. 17. Plotting Survivorship 30 25 20 15 Real Return 10 Volatility 5 Linear (Volatility) 0 -5
  18. 18. Conclusion on Survivorship• U.S. Markets haven‟t had drastic temporary or permanent systematic disruptions • Financial Crisis • War/Invasion on home territory • Hyperinflation• Using U.S. markets does not capture all of the “losers” to offset “winners” - U.S. is the exception to the average• Conclusion: Historical ERP from Ibbotson is approximately 60 basis points (0.6%) overstated
  19. 19. Issues with Ibbotson‟s Historical ERP• Realized ERP vs. Expected ERP• Arnott & Bernstein: Ibbotson Historical ERP Overstated • Expected ERP in 1926 was above long-term premium • Important non-recurring developments were not anticipated by investors• Fama & French: Ibbotson Historical ERP Overstated • Unanticipated decline in discount rates• McGrattan & Prescott • Investors did not expect changes such as: decreases in marginal tax rates and defined benefit and contributions plans• Ibbotson & Chen • Developed forward-looking, long-term sustainable expected ERP
  20. 20. Ibbotson – Supply Side Model• Long-term expected equity returns can be forecasted with supply side models • Supply of stock market returns is generated by the productivity of the corporations in the real economy • Investors should not expect a much higher or lower return • Over the long run, equity returns should be close to long-run supply estimate • Roger G. Ibbotson and Peng Chen forecast the ERP using historical data • Utilize an earnings model as the basis for their supply side estimate • Historically, growth in corporate earnings = growth in overall economic production • Earnings model has four pieces • Inflation • Income return • Growth in real earnings per share • Growth in the P/E ratio (3 year average earnings)
  21. 21. Ibbotson• Build-Up Method • Utilizes various market rates of return and risk premiums • Risk-Free Rate • Long-Term Equity Risk Premium • Specific Company Risk Premium • Cost of Equity = Rf + ERP + SCs • Rf = Risk-Free Rate • ERP = Equity Risk Premium • SCs = Specific Company Risk Premium
  22. 22. Ibbotson - ERP• Data from Ibbotson Associates “Stocks, Bonds, Bills and Inflation 2011 Yearbook” published by Morningstar® • Market risk premium of 6.0 percent (supply side) • Historical equity risk premium minus the P/E ratio calculated using the 3 year average returns • Small company premium • Contingent on size of company • Size decile based on market capitalization • Size premium return in excess of CAPM • Usually consider 10th decile (6.4 percent)
  23. 23. Duff & Phelps‟ ERP Data
  24. 24. Duff and Phelps• Built on the following two fundamentals: • Stock returns can be predicted by measures of size other than market capitalization • Stock returns can be measured by fundamental risk measures based on accounting data• Premise: As size decreases, the returns tend to increase • Small Cap stock higher risk/return potential than large cap stock• Like Ibbotson: Dividing historical data by size • Ibbotson: 10 deciles based on market capitalization • Duff & Phelps: 25 deciles based on multiple measures• Duff & Phelps – Ranking just by market capitalization eliminates: • Inherent bias • “Guesstimating” the market capitalization for privately-held companies
  25. 25. Size and Risk Comparison Size Study – 8 Measures Risk Study – 3 Measures• Market Value of Equity • Operating Margin• Book Value of Equity • Coefficient of Variation in• 5-Year Average Net Operating Margin Income • Coefficient of Variation in• Market Value of Invested Return on Equity Capital• Total Assets• 5-Year Average EBITDA• LTM Sales• No. of Employees
  26. 26. Size Study Overview• Use 8 Factors: • Eliminates bias • Factors other than market capitalization may have factor • Eliminates the need to guess/estimate market capitalization for privately-held companies • More factors better than 1• Use of two cost of equity methods: • Build Up Method: Risk Premium Over Risk Free Rate (“A” Exhibits) • CAPM: Risk Premium over CAPM (“B” Exhibits)
  27. 27. Size Study - Risk Premium Over RiskFree Rate• Difference in historical return of equities over the risk free rate• Long-run average historical risk premium used as indicator of expected risk premium for a typical investor• Returns based on dividend and capital appreciation after corporate taxes, but before shareholder taxes• Difference between income from risk-free asset (20-Year Treasury) and equity security represents size risk and market risk
  28. 28. Build-Up Method – No Regression COE = Rf + RPm+s + RPu + ERPadj Rf Risk Free Rate RPm+s Market & Size Premium RPu Specific Co. Risk ERPadj ERP Adjustment• ERP Adjustment = User‟s ERP – Historical ERP • Difference between user‟s forward looking ERP and D&P‟s historical ERP (4.4%)
  29. 29. Use of Regression Equation• When the subject company size measures do not exactly match the average company size of the guideline portfolios• Exhibits provide method to interpolate the exact risk premium
  30. 30. Size Study: Risk Premium Over CAPM• Beta-adjusted size premium• Unlike Risk Premium over Risk Free Rate, only the size premium is considered • CAPM uses beta which accounts for market risk• Size Premium • Portfolio Premium x (Portfolio beta x Realized Market Premium) • “What actually happened” – “What CAPM predicted would happen”
  31. 31. CAPM Method COE = Rf + (β x ERP) + RPs + RPu Rf Risk Free Rate β Beta ERP Equity Risk Premium RPs Beta Adjusted Size Premium RPu Specific Co. Risk• Beta – Compare with S&P 500• D&P – Recommended ERP is 5.5%
  32. 32. D&P – Risk Study• Risk Study analyzes the relationship between fundamental risk measures and return• Measure of earnings volatility can explain credit ratings, predict insolvency and CAPM Beta• Fundamental Risk Measures • 5-Year Average Operating Income Margin • Coefficient of Variation in Operating Income Margin • Coefficient of Variation in Book Equity Operating Variability Risk Risk Margin of Earnings
  33. 33. Build-Up Method COE = Rf + RPm+u + ERPadj Rf Risk Free Rate RPm+u Market & Specific Co. Risk Premium ERPadj ERP Adjustment• ERP Adjustment = Difference between user‟s forward looking ERP and D&P‟s historical ERP (4.4%)• Build Up Method Only (no CAPM)
  34. 34. Using D&P and Ibbotson Collectively• Use of Ibbotson IRP with Duff & Phelps • Need to adjust the IRP for differences in the estimated ERP • Difference between forward looking ERP and Ibbotson Historical ERP • Adjusted IRP = Ibbotson IRP x (Forward Looking ERP / Ibbotson ERP) • Once Adjusted IRP has been determined, use them in a regular build-up method • Duff & Phelps cautions users that these adjustments might double count the beta effect • CAPM might be better solution• Size premium use okay with CAPM and Build-up method
  35. 35. Economic Challenges and the Impact on the Cost of Equity Components
  36. 36. Economic Challenges - 2008 & 2012 2008 2012• Securitization and • Slow Global Growth Subprime Crisis • Housing Market Remains• Lack of Liquidity and Depressed Available Credit • European Debt Crisis• Housing Market Collapse • Downgrades of Debt• Extreme Volatility • High Unemployment• Government Bailouts • Low Interest Rate Levels
  37. 37. Challenges to the Cost of Equity• Economic conditions has presented historically uncommon levels of risk/return levels • Substantially changed interest rates • Substantially changed risk premiums • Today‟s economic climate not supported by historic data• Changes in investor‟s expectations and behavior• Changes to risk treatments• Recent shift from risk retention to risk avoidance - “Flight to Quality”• Historically low interest rates
  38. 38. ERP During Periods of “Flight to Quality”• Any estimate of ERP must be made in relation to a risk- free security • Expected return of a company‟s equity investors must be measured in its relationship to the rate of return on a risk-free security • Function of the holding period for the investment • Short-term holding period U.S. Government short-term security • Long-term holding period Long-term U.S. Government bond • Valuing a business = long-term investment
  39. 39. Conditional Estimate of ERP and the Great Recession• September 2008 – Economy plunges into crisis• Long-term trend in large company stocks parallels ERP estimate over time• Stock market goes through cycles • Decline from the long-term average (i.e. last half of 2008) • Conditional ERP will be greater than the average for some time • Average over the long-run to return to the average • Below average for a period (losses during 2008) • ERP will be higher to then get back to average • As stock market declined and risk increased, implied ERP estimates increased while realized risk premiums decreased • Estimate ERP using a method just like “normal” times, estimate would be flawed
  40. 40. Conditional ERP at Trough of Stock Market Cycle
  41. 41. Estimating ERP during Recession• 2008 – 2010 not ordinary times• Standard practice of practitioners utilizes “spot” yield • 20-year U.S. government bonds • Add to arithmetic average of realized risk premiums from Ibbotson, etc. as the base of capital estimate • Methodology has created many erroneous estimates • December 2007 yield on 20-year U.S. Gov‟t Bonds = 4.5% • December 2008 yield on 20-year U.S. Gov‟t Bonds = 3.0% • Risk in economy increased • Base cost of equity capital using risk premiums decreased • Similar scenario in 2010 • European sovereign debt crisis causes base cost of equity to be understated
  42. 42. Implied Volatility and the ERP• Implied volatility is the market‟s best estimate of future volatility over the term of the option • Crisis begins in September 2008 • Stock market moves down • Fear envelops the financial markets • Implied volatilities increased in S&P 500 and long-term U.S. bonds • Peaked in October – December 2008 period • Concurrently, interest rates on U.S. bills and bonds decline • Levels below those justified by the real rate of interest plus inflation • Increased volatility in the expected interest rates • Market questioned sustainability • Uncertainty about the trajectory of economic and financial markets
  43. 43. Implied ERP Estimates and the Risk-Free Rate• Actual risk-free rates versus normalized risk-free rates • ERP against actual risk free rates ERP greater • Risk-free rates are lower than one would expect given: • Real rate of interest • Inflation expectations • Reinvestment risk • Using a normalized risk-free rate and benchmarking one‟s estimate of ERP against the normalized should be implemented 1. Any period in which the risk-free rate is reduced due to flight-to-quality, one must re-estimate the ERP 2. Monthly re-estimate of ERP assumes that the implied ERP model is accurate and that inputs are updated 3. Given that we are valuing an entire business, do the values of the subject business actually change monthly?
  44. 44. Conclusion of Adjustments to ERP• Normal ERP is a range reflecting the principle investor‟s expectations are NOT homogeneous• Different investors have different cash flow expectations • Different future assessments of risk• Estimating ERP is one of the most important issues in Cost of Capital of a subject business • Consider variety of sources • Examine realized returns over various periods • Employ forward looking estimates• What is reasonable estimate of unconditional (long-range) ERP?
  45. 45. Global GT LP and Global GT LTD v.Golden Telecom, Inc.• Del. Court of Chancery, April 23, 2010• Golden‟s expert selected 7.1% long-term ERP • Based on Ibbotson SBBI Valuation Yearbook• Petitioner‟s expert selected ERP of 6.0% • Based on teaching experience, relevant empirical literature, „supply side‟ ERP reported in Ibbotson Yearbook• Court rejected the use of the ERP based solely on Ibbotson • “…relevant professional community has mined additional data and pondered the reliability of past practice and come, by a healthy weight of reasoned opinion, to believe that a different practice should become the norm…”
  46. 46. Risk-Free Rate• Reflects three components: 1. Rental Rate – real return for lending funds over the investment period 2. Inflation – expected rate of inflation over the term 3. Maturity Risk – (investment rate risk) risk that the investment‟s principal market value will rise or fall during the period to maturity due to changes in interest rates • All three of these economic factors are embedded in the yield to maturity for any given maturity length
  47. 47. Risk-Free Rate - Inflation• Basic risk-free rate includes inflation expectations • When projecting cost of capital to discount future net cash flows; net cash flows should also reflect the expected effect of inflation • Building cost of capital in nominal terms v. real dollars • Nominal = goal or approximation as opposed to real value • Estimate long-term economic inflation forecast by taking difference in yield in risk-free security and the yield on TIPS (Treasury Inflation-Protected Securities)
  48. 48. Risk-Free Rate – “Going-Concern” Businesses• Valuing “Going-Concern” Businesses • Generally use long-term U.S. government bonds as risk-free security • Estimate ERP in relation to long-term U.S. government bonds • Most business investments have long durations • Suffer from a reinvestment risk comparable to long-term U.S. government bonds • As such, an ERP estimated relative to long-term bonds reflects the investment horizon and risks confronting valuators • Most use 20-year (constant maturity) U.S. government bond yield to maturity as of the valuation date • 10-year or 30-year may be applicable depending on each unique situation
  49. 49. Risk-Free Rate - Appropriateness• Use of Risk-Free Rate as building block for Cost of Equity Capital still appropriate? • 2008 financial crisis • U.S. government security yields declined • Long-term U.S. government bond yields diminished to abnormally low levels • Thus, the typical benchmark used in Cost of Equity Capital models became abnormally low • Leads to inaccurate indications of value
  50. 50. U.S. Government Bond Yields
  51. 51. Risk-Free Rate - Adjustment• Market interest rate influenced by a “Flight to Quality”? • “Flight of Quality” – the action of investors moving their capital away from riskier investments to the safest possible investment vehicles • Uncertainty in the financial or international markets • U.S. Economic Recovery • European Sovereign Debt Crisis • QE (Quantitative Easing) Purchases • Assess the changes in the market interest rates and other economic indicators • Flow of Funds • Implied Volatility of Options • Changes in Estimated Inflation • If market rates prove abnormally low, use a build-up approach to normalize • Consider historic averages • Real rate of interest • Inflation estimates
  52. 52. Damodaran Online• Published by Aswath Damodaran – Professor of Finance at the Stern School of Business at NYU• Publishes Monthly Cost of Equity Component data online• Assumption: When using historical ERP, we assume the ERP will not change much over short periods of time and revert back over time to historical averages • Reasonable for mature equity markets? • Example: Fall of Lehman Brothers and subsequent equity collapse • ERP on Oct 10: High of 6.6%, Low of 6.1% • Might be better to look at data monthly, rather than annually
  53. 53. Damodaran Monthly Data• Two Ways to View ERP Volatility • Once crisis has passed, ERP will return to status quo • Crisis should be ignored and move to ERP at status quo for mature markets (i.e. ERP fixed near 5-6%) • Once crisis has passed, ERP won‟t return to status quo right away • Crisis is a structural shift in markets and ERP should be modified to reflect market changes• Damodaran argues a combination of both • ERP should be assessment of the Company, not purely the equity markets
  54. 54. Recent ERP Trends14.0%12.0%10.0%8.0%6.0% ERP4.0% Risk Free Rate2.0%0.0%
  55. 55. Monthly Data Calculation• Data Sources: • Value Line – For U.S. Data • Capital IQ – For International Data • Bloomberg – For International Data• Uses a 2-stage model • Projects expected distributions • Dividends and stock buy-backs • Based on average of analyst estimates for earnings growth for firms comprising S&P 500 • Calculates for first 5 years • Expects growth to equal risk-free rate thereafter • Solves for expected return (discount rate) • Equates distributions to current levels of S&P 500 • Benchmarks his implied ERP estimates • Subtracts current yield on 10-year U.S. bonds from expected return of S&P
  56. 56. Incorporating it into Report?• Good tool to estimate value for appraisal updates• Helps better understand swings in market risks and unsystematic risks• Might assist in development of financial forecasts/projections• What does Damodaran think? • Does not recommend data to be used in legal arena • Experts should not put much weight into data • Not transparent in how many of his data collections are calculated • No authoritative support or evidence this would beat annual data
  57. 57. Questions?