Société Française des Evaluateurs Cost of Capital Update. October 2, 2014

Transcription

1 Société Française des Evaluateurs Cost of Capital Update October 2, 2014

2 Disclaimer Any opinions presented in this seminar are those of Roger J. Grabowski and do not represent the official position of Duff & Phelps, LLC. This material is offered for educational purposes with the understanding that neither the authors nor Duff & Phelps, LLC are engaged in rendering legal, accounting or any other professional service through presentation of this material. The information presented in this seminar has been obtained with the greatest of care from sources believed to be reliable, but is not guaranteed to be complete, accurate or timely. The authors and Duff & Phelps LLC expressly disclaim any liability, including incidental or consequential damages, arising from the use of this material or any errors or omissions that may be contained in it. 2

3 Outline Morningstar exits the valuation market Cost of capital resources New Developments from Cost of Capital: Applications and Examples 5th ed. Additional residual value models Risk-free rate impact of quantitative easing Equity risk premium o Unconditional o Conditional Adjusting discount rates to alternative measures of economic income 3

4 Morningstar Exits the Valuation Market Morningstar announced in late September, 2013, that it will no longer publish valuation publications and products: SBBI Valuation Edition discontinued Ibbotson SBBI Valuation Yearbook (with data through Dec. 31, 2012) was Morningstar s last Ibbotson SBBI Valuation Yearbook Discontinued: o o Breakout of the 10th decile into 10a and 10b or 10w, 10x, 10y, and 10z Industry Risk Premia for use in build-up method Ibbotson SBBI Classic Edition continuing Size premia for CRSP standard market-cap-weighted deciles 1-10 only Supply-Side Equity Risk Premium The Ibbotson SBBI Classic Edition is an analysis of the relative performance of various asset classes in the U.S., and does not provide extensive valuation data or methodology. 4

5 Other Discounted Valuation Publications and Products Hardcover Books and PDFs (discontinued) CCRC.Morningstar.com website (discontinued) Ibbotson SBBI Valuation Yearbook SBBI Valuation Essentials module* Individual Company Betas (in PDF format) Ibbotson Cost of Capital Yearbook International Cost of Capital Reports (in PDF format) Company Betas module (also sold seperately as PDF "tear" sheets) Industry Analysis module** (also sold seperately as PDF "tear" sheets) Int'l Cost of Capital module (also sold seperately as individual PDF reports) Int'l Cost of Capital Report Int'l Cost of Capital Perspective Report Int'l Equity Risk Premium Report * These reports included the most "essential" information from each of the SBBI Valuation Yearbook (in PDF format). ** These reports were individual industry analysis pages from the Ibbotson Cost of Capital Yearbook, over time (in PDF format). 5

6 New 2014 Valuation Handbook Guide to Cost of Capital Includes all of the key year-end data that was previously available in the Ibbotson SBBI Valuation Yearbook (Shipping began March 17, 2014) Includes two sets of valuation data: Data previously available in the Ibbotson SBBI Valuation Yearbook; and Data available in Duff & Phelps Risk Premium Report. o No longer published as stand-alone publication 6

7 Valuation Handbook Guide to Cost of Capital Includes all of the key variables in estimating the cost of equity capital previously published on the SBBI Yearbook s back page plus added data: Yields Long-term (20-year) U.S. Treasury Coupon Bond Yield as of December 31, 2013 Equity Risk Premiums Ibbotson Long-horizon expected historical equity risk premium ( ) Ibbotson Long-horizon expected supply side equity risk premium ( ) Plus: Conditional ERP as of January 1, 2014 Size Premia 1. CRSP Mid-Cap, Low-Cap, and Micro-Cap size premia 2. CRSP Deciles 1 through 10 size premia 3. Size premia for the breakdown of CRSP Decile 10 into 10a (and its subdeciles 10w and 10x) and 10b (and its subdeciles 10y and 10z) 4. Plus: Size premia from Risk Premium Report 7

8 Valuation Handbook Guide to Cost of Capital Industry Risk Premium Industry risk premia (IRPs) previously found in Table 3-5 in the Ibbotson SBBI Valuation Yearbook for use in the build-up method (updated quarterly) Plus: expanded data: Full-information betas by SIC code IRPs based on three estimates of ERP o Long-term Historical ERP ( ) o Long-term Supply-side ( ) o Conditional ERP as of January 1, Duff & Phelps recommended ERP 8

9 Valuation Handbook Guide to Cost of Capital The same data sources used to produce the data in the former Ibbotson SBBI Valuation Yearbook are used to produce the new Valuation Handbook: 1. The Center for Research in Security Prices (CRSP) market-capbased NYSE/AMEX/NASDAQ indices; 2. Standard & Poor s Research Insight database; and 3. SBBI Series from Morningstar s EnCorr database. The same methodologies are used to produce the new Valuation Handbook as were used in the former Ibbotson SBBI Valuation Yearbook. 9

10 Valuation Handbook Guide to Cost of Capital Risk Premium Report includes: Size Study: Size premia based on 8 size measures For build-up method For CAPM Risk Study: Risk premia based on 3 measures of fundamental risk For build-up method Plus: Comparative risk characteristics- relationship of size to other risk characteristics Plus: Returns for high-financial-risk companies 10

11 Cost of Capital Resources Comprehensive overview of theory and proper use of data. Updated every 4 years. High-level primer on valuation theory. Annual update of critical valuation data (ERP, size premia, industry risk premia). 11

12 Alternative Data Sources International cost of capital data Credit Suisse Global Investment Returns Sourcebook and Yearbook 2014 by Elroy Dimson, Paul Marsh, and Mike Staunton 21 countries Damodaran website Market Risk Premium used in 88 countries in 2014: a survey with 8,228 answers by Pablo Fernandez, Palo Linares, and Isabel Fernandez Acin 12

13 Credit Suisse Global Investment Returns Sourcebook 2014 (Relative to Bills) Table 9: Worldwide equity risk premiums relative to bills, Country Geometric Arithmetic Standard Standard Minimum Min Maximum Max mean% mean% error% dev.% return% year return% year Australia Austria Belgium Canada Denmark Finland France Germany* Ireland Italy Japan The Netherlands New Zealand 4.3 5, Norway Portugal South Africa Spain Sweden Switzerland ' United Kingdom United States Europe World ex-usa World ' For Austria and Germany, statistics are based on 112 years, excluding for Austria and for Germany. Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists, Princeton University Press, 2002, and subsequent research. 13

14 Credit Suisse Global Investment Returns Sourcebook 2014 (Relative to Bonds) Table 10: Worldwide risk premiums relative to bonds, Country Geometric Arithmetic Standard Standard Minimum Min Maximum Max mean% mean% error% dev.% return% year return% year Australia Austria Belgium Canada Denmark Finland France Germany' Ireland Italy Japan The Netherlands New Zealand Norway Portugal South Africa Spain Sweden Switzerland United Kingdom United States Europe World ex-usa World ' For Austria and Germany, statistics are based on 112 years, excluding for Austria and for Germany. Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists, Princeton University Press, 2002, and subsequent research. 14

15 Credit Suisse Global Investment Returns Sourcebook 2014 Table 11: Decomposition of the historical risk premium, (% p.a.) Geometric mean dividend yield plus* Growth rate of real dividends plus Expansion in the P/D ratio plus Change in the real exchange minus US real interest rate equals Equity premium for US Country Australia Austria** Belgium Canada Denmark Finland France Germany" Ireland Italy Japan The Netherlands New Zealand Norway Portugal South Africa Spain Sweden Switzerland United Kingdom United States Average Standard deviation World (USD) * Premiums are relative to bills. Summations and subtractions are geometric. ** For Austria and Germany, statistics are based on 112 years, excluding for Austria and for Germany. Source: Elroy Dimson, Paul M arsh, and M ike Staunton, The Worldwide Equity Premium: A Smaller Puzzle, in R. M ehra (Ed.), Handbook of the Equity Risk Premium, Elsevier, 2008, and subsequent research. 15

16 Market Risk Premium used in 88 Countries in 2014: IESE Business School June 20, 2014 a Survey with 8,228 Answers Comparison of Market Risk Premium Results of the Surveys of 2011, 2012, 2013 and 2014 Average (%) Median (%) Standard Deviation (%) Country Australia Austria Belgium Brazil Canada China Czech Republic Denmark Finland France Germany Greece India Ireland Italy Japan Netherlands Norway Poland Portugal Russia South Africa Spain United Kingdom United States Source: Fernandez, Pablo and Linares, Pablo and Fernández Acín, Isabel, Market Risk Premium Used in 88 Countries in 2014: A Survey with 8,228 Answers (June 20, 2014). 16

17 Market Risk Premium (%) Market Risk Premium used in 88 Countries in 2014: IESE Business School June 20, 2014 a Survey with 8,228 Answers Average +/- 1 St. Dev Source: Fernandez, Pablo and Linares, Pablo and Fernández Acín, Isabel, Market Risk Premium Used in 88 Countries in 2014: A Survey with 8,228 Answers (June 20, 2014). 17

18 Default Spread Model & CDS Model by Professor Damodaran As of December 31, 2013 Default Spread Model CDS Model Country Rating-based Default Total Equity Risk Country Risk Total Equity Risk Country Risk CDS Default Spread Spread Premium Premium Premium Premium Argentina 6.50% 14.75% 9.75% 14.73% 26.24% 21.24% Brazil 1.90% 7.85% 2.85% 2.53% 7.94% 2.94% Hong Kong 0.40% 5.60% 0.60% 0.91% 5.51% 0.51% Hungary 2.50% 8.75% 3.75% 3.08% 8.77% 3.77% Iceland 2.20% 8.30% 3.30% 2.19% 7.43% 2.43% India 2.20% 8.30% 3.30% 3.51% 9.41% 4.41% Italy 1.90% 7.85% 2.85% 2.11% 7.31% 2.31% Japan 0.60% 5.90% 0.90% 0.79% 5.33% 0.33% Philippines 2.20% 8.30% 3.30% 1.81% 6.86% 1.86% Poland 0.85% 6.28% 1.28% 1.28% 6.07% 1.07% Portugal 3.60% 10.40% 5.40% 4.03% 10.19% 5.19% Romania 2.20% 8.30% 3.30% 2.61% 8.06% 3.06% Russia 1.60% 7.40% 2.40% 2.21% 7.46% 2.46% South Africa 1.60% 7.40% 2.40% 2.75% 8.27% 3.27% Spain 2.20% 8.30% 3.30% 1.96% 7.09% 2.09% United Arab Emirates 0.50% 5.75% 0.75% 2.88% 8.47% 3.47% United Kingdom 0.40% 5.60% 0.60% 0.57% 5.00% 0.00% United States of America 0.00% 5.00% 0.00% 0.46% 5.00% 0.00% Venezuela 7.50% 16.25% 11.25% 10.80% 20.35% 15.35% Source: Undated Annually. Damodaran, Aswath, Equity Risk Premiums (ERP): Determinants, Estimation and Implications The 2013 Edition (March 23, 2013). 18

19 Valuation Handbook Industry Cost of Capital The 2014 Valuation Handbook Industry Cost of Capital includes cost of capital estimates (equity capital, debt capital, and WACC) for over 200 U.S. industries, plus a host of detailed statistics that can be used for benchmarking purposes. 19

20 Valuation Handbook Industry Cost of Capital Like Morningstar s Ibbotson Cost of Capital Yearbook which is no longer published, the new 2014 Valuation Handbook Industry Cost of Capital is published with data through March 2014, and will include three intra-year Quarterly Updates (June, September, and December). Quarterly Updates are optional, and are not sold separately. 20

21 Valuation Handbook Industry Cost of Capital The 2014 Valuation Handbook Industry Cost of Capital provides eight (8) cost of equity capital estimates for each of the industries covered in the book: Capital Asset Pricing Model (CAPM) CAPM + Size Premium (using the CRSP Decile Size Study) Build-up + Industry Risk Premium (using the CRSP Decile Size Study) CAPM + Size Premium (using the Risk Premium Report Study) Build-up + Risk Premium Over the Risk-free Rate (using the Risk Premium Report Study) 1-Stage Discounted Cash Flow (DCF) model 3-Stage DCF model Fama-French 3-Factor model 21

22 Valuation Handbook Industry Cost of Capital Cost of debt capital and weighted average cost of capital (WACC) are also presented for each industry. Detailed statistics (some of which were previously unavailable): Sales, market capitalization, capital structure, industry performance Various levered and unlevered beta estimates (e.g., ordinary least squares (OLS) beta, sumbeta, downside beta, etc.), Valuation (trading) multiples, financial and profitability ratios, equity returns, aggregate forward-looking EPS growth rates, and more. 22

23 Valuation Handbook Industry Cost of Capital Analysis of Capital Structure Including Off-Balance-Sheet Liabilities New statistics that enable the user to gauge the impact of debtlike off-balance sheet items on the capital structure of the subject industry. These debt-equivalent liabilities (specifically, operating leases and unfunded pension liabilities) are not only taken into account by credit rating agencies when assigning a debt rating for a company, but should likely be considered as well when ascertaining the true financial (and equity) risk of the subject company. The capital structure (and unlevered betas) of each industry are calculated two ways: with and without these off-balance-sheet debt items, so that the user can ascertain how material these liabilities are for the subject industry. 23

24 Exhibit 11: Distribution of Company-level Average WACC by Industry 24

25 Exhibit 12: Average and Median of Company-level Average WAC by Industry for Healthy Companies and High-Finance-Risk Companies 25

26 26

27 Cost of Capital is a Function of the Investment As Ibbotson puts it: The cost of capital is a function of the investment, not the investor. The cost of capital comes from the marketplace, and the marketplace is the pool of investors pricing the risk of a particular asset. Thus it represents the consensus assessment of the pool of investors that are participants in a particular market. 27

28 Cost of Capital is Forward-Looking The cost of capital represents investors expectations. Elements to these expectations: 1. Risk-free rate: Rental rate Inflation (and inflation risk premium) Maturity risk. 2. Risk premium the added return expected by market participants to compensate them for uncertainty as to when and how much cash flow or other economic income will be received 28

29 How Risk is Priced is Still a Relative Unknown Professor John Cochrane recently discussed the changes in our knowledge of estimating rates of return for equity over the last 40 years: In the beginning, there was chaos. Then came CAPM. Every clever strategy to deliver high returns ended up delivering high market betas as well. Then anomalies erupted and there was chaos again. Researchers such as Professors Fama and French found that market returns were a function of other factors and not simply market betas. CAPM as it is taught predicts that on the average portfolios of stocks with high beta estimates will earn greater returns than portfolios of stocks with low beta estimates. In fact, we find that variation in returns is not explained by differences in market betas. Rather differences in returns are explained by a zoo of new variables. John C. Cochrane, University of Chicago Booth School of Business, Discount Rates, American Finance Association Presidential Address, January 8,

30 How Risk is Priced is Still a Relative Unknown (cont d) Professor Cochrane concludes: Discount rates vary a lot more than we thought. The puzzles and anomalies that we face amount to discount rate variation we don t understand. Our theoretical controversies are about how discount rates are formed.theories are in their infancy. Cost of capital is all about pricing risk- matching the risk inherent in the net cash flows with the rate of return demanded by the market for accepting that level of risk. Probably the most widely accepted definition of risk in the context of business valuation is the degree of uncertainty of achieving future expectations at the times and in the amounts forecast. 30

31 How Risk is Priced is Still a Relative Unknown (cont d) While the textbook capital asset pricing model (CAPM) is the most widely used asset pricing model, risk pricing has moved beyond considering CAPM beta as the sole measure of risk. Empirical tests of CAPM have shown that textbook CAPM does not do a good job in pricing risk: High (low) beta stocks do not generate high (low) returns Is beta measurement the problem: beta a forward measure of risk, yet we use backwards looking methods to estimate beta Do we just misinterpret the nature of the risk beta is measuring? Does the market price more factors (systematic risks measures) beyond beta? 31

32 CAPM Modified Into Multi-factor Model R i = R f + B i,m RP m + B i,s RP i,s + B i,bv RP i,bv + + B i,c RP i,c + + ε i where: R i R f B i,m = Realized return for stock of company i = Risk-free rate of return = Sensitivity of return of stock of company i to the market risk premium, RP m (ERP) B i,s = Sensitivity of return of stock of company i to a measure of size, S, of company i and S i = Measure of size of company i RP i,s = B i,s x S i = Risk premium for size of company i B i,bv = Sensitivity of return of stock of company i to a measure of BV (typically measure of bookvalue-to-market-value) of stock of company i and BV i RP i,bv = B i,bv x BV i = Risk premium for book value of company i B i,c U c = Other factors = Sensitivity of return of stock of company i to a measure of unique (company, industry) risk of company i = Measure of unique risk of company i RP i,c = B i,c x U c = Risk premium for unique risk of company i ε i = Error term, difference between predicted return and realized return. 32

33 Cost of Capital 5th ed. Introduces Additional Residual Value Models In applying a DCF, residual value model should reflect: Sustainable long-term net cash flows Long-term growth rate in net cash flows Management often provides estimates of discrete period net cash flows for only short periods of time (e.g., 1 year, 3 years, 5 years) leaving it to the analyst to Estimate long-term sustainable growth rate Estimate time before net cash flows reach steady-state Normalize the net cash flows consistent with steady state 33

34 Combining Discounting and Capitalizing Typical two-stage model (assuming that net cash flows are received at the end of each year): where: NCF 1 NCF n k g = Net cash flow expected in each of the periods 1 through n, n being the last period of the discrete net cash flow projections = Discount rate (cost of capital) = Expected sustainable long-term growth rate in net cash flow, starting with the last period of the discrete projections as the base year 34

35 Expanded Residual Value Model Three-stage model (assuming that net cash flows are received at the end of each year): where: NCF 1 NCF n = Net cash flow expected in each of the periods 1 through n, n being the last period of the discrete net cash flow projections k = Discount rate (cost of capital) g 1 = Expected sustainable growth rate in net cash flow, starting with the last period of the discrete projections, n, as the base year for m years g 2 = Expected sustainable long-term growth rate in net cash flow, starting with the last period of the discrete projections as the base year having increased at the rate g 1 for m years. We would typically expect that g 2 was less than g 1. 35

36 Expanded Residual Value Model - Gradual Change in Growth Assuming net cash flows are received at the end of each year: where: NCF 1 NCF n = Net cash flow expected in each of the periods 1 through n, n being the last period of the discrete net cash flow projections k = Discount rate (cost of capital) g 1 = Expected sustainable growth rate in net cash flow, starting with the last period of the discrete projections, n, as the base year for m years g 2 = Expected sustainable long-term growth rate in net cash flow, starting in year m + 1 H = Half-life of the transition from g 1 to g 2 = (m / 2). 36

37 Changing Risk Over Time If the underlying risk is expected to change over time, the discount rate will change as well. The net cash flows of a business are not independent of each other rather they are dependent (or conditional), the discount factors for later years are dependent upon prior year discount factors. Discounting net cash flows assuming single period discount rates (build-up or CAPM) and end of year net cash flows: 37

38 Changing Risk Over Time (cont d) Assume that the principal product of the subject business is patented and that the patent expires two years following the valuation date. One would expect that net cash flows in year three and thereafter will likely change (e.g., profit margins will likely decrease as a result of increased competition following expiration of the patent). But we would expect that the riskiness of those expected net cash flows would also increase (e.g., expected volatility of the cash flows will likely increase as the result of increased competition). The net cash flows of a business are not independent of each other. 38

39 Changing Risk Over Time (cont d) The net cash flows of year three, for example, build on the net cash flow and business operations in years one and two. Expenditures on advertising and sales calls to prospective customers in year one and two created demand for the business s goods and service in year three and thereafter. Capital expenditure in years one and two provide the capability of meeting customer demand in year three and thereafter. In year three, even though the patent has expired, much of that year s net cash flow is still dependent on expenditures made in prior years. 39

40 Changing Risk Over Time (cont d) Assume that k 1 =12% and k 2 =20%: 40

41 Components of the Risk-Free Rate The so-called risk-free rate reflects three components: 1. Rental rate: Real return for lending the funds free of default risk, thus foregoing consumption for which the funds otherwise could be used. 2. Inflation (and inflation risk premium): Expected rate of inflation over the term of the risk-free investment (and the risk that expected inflation will increase). 3. Maturity risk (also called investment rate risk or term risk): Risk that the investment's principal market value will rise or fall during the period to maturity as a function of changes in the general level of interest rates All three of these economic factors are embedded in the yield to maturity for any given maturity length. It is not possible to observe the market consensus about how much of the yield for any given maturity is attributable to these factors. 41

42 Real Interest Rates Some academic studies have suggested the long-term real risk-free rate to be somewhere in the range of 1.3% to 2.0% based on the study of inflation swap rates and/or yields on long-term U.S. Treasury Inflation-Protected Securities (TIPS) The average yield on long-term TIPS and use these as a proxy for the long-term real rate. The average monthly 20-year TIPS yield from = 1.7%. 42

43 Inflation Expectations Issues with estimating expected inflation based on Treasury inflation-protected securities (TIPS). Breakeven inflation rate is the difference between the U.S. Treasury yield (nominal) and TIPS yield of similar maturity (real). Breakeven inflation is not a good reflection of inflation expectations because there are other factors that the TIPS yield may be capturing (e.g. liquidity premium, inflation risk premium, etc.) Surveys provide consensus inflation expectations 43

44 Long-Term Inflation Estimates (early 2013) There are a number of well-established surveys providing consensus estimates for expected inflation: Source Estimate (%) Livingston Survey (Federal Reserve Bank of Philadelphia) Survey of Professional Forecasters (Federal Reserve Bank of Philadelphia) Blue Chip Financial Forecasts 2.4 University of Michigan Survey 5-10 Year Ahead Inflation Expectations 3.0 Range of Expected Inflation Forecasts 2.3% 3.0% In addition, the Congressional Budget Office forecasts inflation of approximately 2.0% per annum through

45 Build-up of Nominal Risk-free Rate Combining the range of long-term real rates (1.3% to 2.0%) and the range of expected inflation forecasts (2.3% to 3.0%) gives us an estimated build-up of the risk-free rate that falls in the range of 3.6% to 5.0%. The midpoint of this risk-free rate range using the simple buildup method employed in this example = 4.3%. 45

46 Selecting the Best Risk-free Yield Since the 2008 Crisis and the large-scale monetary interventions that followed, yields of the 20-year U.S. government bonds have been significantly lower than both recent average and longer-term average monthly yields. In these circumstances should the analyst use the current market yield on risk-free U.S. government bonds or use a normalized risk-free yield based on the build-up when estimating the cost of equity? 20-year U.S. government bond spot rate yield to maturity at June 30, 2014 was 3.08%. 46

47 Selecting the Best Risk-free Yield (cont d) Analysts would prefer to use the spot yield on U.S. government bonds available in the market as a proxy for the U.S. risk-free rate. However, during times of flight to quality and/or high levels of central bank intervention, those lower observed yields imply a lower cost of capital (all other factors held the same) the opposite of what one would expect in times of relative economy-wide distress and so a normalization adjustment may be considered appropriate. By normalization we mean estimating a rate that more likely reflects the sustainable average return of long-term risk-free rates. If spot yield-to-maturity were used in these times, without any other adjustments, one would arrive at an overall discount rate that is likely inappropriately low vis-à-vis the risk currently facing investors. 47

48 Defining the Equity Risk Premium (ERP) The ERP (or notational RP m ) is defined as: RP m = R m R f RP m = Expected equity risk premium R m = Expected return on a fully diversified portfolios of equity securities R f = Expected rate of return on a risk-free security The ERP is expectational (i.e., forward-looking) over the expected duration of the net cash flows. 48

49 Estimating the ERP There is no one universally accepted methodology for estimating the ERP. A wide variety of premiums are used in practice and recommended by academics and financial advisors. These differences are often due to differences in how the ERP is estimated. Generally, we can categorize approaches for estimating the ERP as either an ex post approach or an ex ante approach. Ex post approaches: expected returns on common stocks implied by averages of realized (historical) single period returns (or realized multiyear compound returns). Ex post approaches: the expected returns on the diversified portfolio implied by expected (future) stock prices or expected dividends. Any estimate of the ERP must be made in relation to a risk-free security. That is, the expected return on a fully diversified portfolio of equity securities must be measured in its relationship to the rate of return expected on a risk-free security. 49

50 Unconditional Equity Risk Premium The Unconditional ERP is the long-term average ERP. The unconditional ERP is typically based on realized (historical) risk premium data. This is referred to as the ex post approach to estimating the ERP. While the ERP is a forward-looking concept, some practitioners (including taxing authorities and regulatory bodies) use historical data to estimate the ERP under the assumption that historical data are a valid proxy for current investor expectations. This provides the appearance of accuracy, but is only accurate to the extent that the past repeats itself. An ex post estimate of the ERP is generally the risk premium (realized return on stocks in excess of the risk-free rate) that investors have, on the average, realized over some historical holding period. Long-term average of realized risk premiums is calculated from varying rates of returns on common stocks over shifting risk-free rates. Generally reported annually. 50

51 Unconditional ERP (cont d) A common practice is to add the same long-term average realized risk premium (an ex post estimate of the ERP) to the market interest rate of the risk-free security throughout the following year regardless of the level of the rate on that security as of the valuation date. This common practice implicitly assumes either that: During upcoming periods the difference between the expected return on common stocks and U.S. government bonds is constant or Any decrease or increase in the ERP as of the valuation date is short-term and that the ERP is mean reverting to the long-term average of realized risk premiums rather quickly. 51

52 Unconditional ERP (cont d) Researchers estimating the long-term average ERP adjust average realized risk premiums for what they believe were non-recurring factors in prior periods or changing economic conditions: Upwards drift in price-to-earnings ratios WWII Interest Rate Bias 52

53 Adjusting for Upwards Drift in Price-to-Earnings Ratios Ibbotson and Chen report on a study in which they estimated forward-looking long-term sustainable equity returns and expected ERPs since 1926 given the underlying economics (the supply side model estimate) remove upwards drift in price-to-earnings ratios Goetzmann and Ibbotson, commenting on the supply side approach of estimating expected risk premiums, note: These forecasts tend to give somewhat lower forecasts than historical risk premiums, primarily because part of the total returns of the stock market have come from price-earnings ratio expansion. This expansion is not predicted to continue indefinitely, and should logically be removed from the expected risk premium. 53

54 Adjusting for Bias in Realized Risk Premium Data Years 1942 through 1951 reflected a period of artificial stability in U.S. government bond interest rates. During World War II, the U.S. Treasury decreed that interest rates had to be kept at artificially low levels in order to reduce government financing costs. This led to the Federal Reserve s April 1942 public commitment to maintain an interest rate ceiling on government debt, both long term and short term. After World War II, the Fed continued maintaining an interest rate ceiling, due to the Treasury s pressure and, to a lesser extent, a fear of returning to the high unemployment levels of the Great Depression. But postwar inflationary pressures caused the Treasury and the Fed to reach an accord in early 1951, freeing the Fed of its obligation of pegging interest rates. Created an upward bias in realized risk premium data from approximately 1.12% 54

55 Unconditional ERP Estimates Long-Term ERP Estimates Measured Relative to Long-Term U.S. Government Bonds (Source: Cost of Capital: Applications and Examples 5 th ed.) ADJUSTED REALIZED RISK PREMIUMS PERIOD ARITHMETIC AVERAGE GEOMETRIC AVERAGE Arnott and Bernstein % 2.4% Arnott % - 5.0% 2.0% - 3.0% Fama and French % 3.6% 1.3% 2.3% SBBI Supply Side % 3.3% Dimson et al % 4.7% 2.9% 3.3% Grinold, Kroner & Various % 2.6% Siegel SBBI Supply Side % 1 or 4.9% % 1 1. Source: SBBI 2013 Valuation Yearbook: Supply-side ERP (6.11%) minus World War II Interest Rate bias (1.17%). 55

56 Unconditional ERP Estimates Reported in the 2014 Valuation Handbook Guide to Cost of Capital: 1. Ibbotson Long-horizon expected historical equity risk premium ( ) = 6.96% 2. Ibbotson Long-horizon expected supply side equity risk premium ( ) = 6.18% 3. Long-horizon expected supply side equity risk premium ( ) adjusted for WWII Interest Rate Bias = 5.06% 56

57 Problem with relying on unadjusted Ibbotson Historical ERP Sources of underlying data: 1.) CRSP U.S. Stock Database and CRSP U.S. Indices Database 2014 Center for Research in Security Prices (CRSP ), University of Chicago Booth School of Business. 2.) Morningstar EnCorr database. Used with permission. All rights reserved. Calculations performed by Duff & Phelps LLC.. 57

58 Conditional ERP ERP is cyclical - conditional ERP represents ERP at specific point in the cycle. Forward-looking (ex ante) approaches can be grouped into four categories: Bottom-up implied ERP estimates Typically uses expected growth in earnings or dividends as a basis for estimating a bottom-up, company-by-company rate of return for the companies in the universe analyzed. Top-down implied ERP estimates Typically uses expected growth in earnings or dividends for the aggregate of the companies comprising a stock index (e.g., the S&P 500), not company-by-company. Top-down risk premium estimates This approach estimates the ERP or changes in the ERP using observed relationships between interest rates or other factors that impact the ERP. Surveys This approach relies on opinions of investors and financial professionals through surveys of their views on the prospects of the overall market and the return expected in excess of a risk-free benchmark. 58

59 Conditional ERP Estimates Long-Term ERP Estimates Measured Relative to Long-Term U.S. Government Bonds at the Beginning of 2013 (Source: Cost of Capital: Applications and Examples 5 th ed.) IMPLIED RISK PREMIUMS BOTTOM- UP ESTIMATES PERIOD ARITHMETIC AVERAGE EQUIVALENT 1 IMPLIED ERP GEOMETRIC AVERAGE 1 BofAML Jun % % Cost of Capital Yearbook TOP-DOWN ESTIMATES Mar % % Damodaran Implied Jun % % Hassett RPF Jun % NA Duff & Phelps Jun % 5 NA SURVEY ESTIMATES Graham and Harvey Late % 3 1.5% 4 1 Measured relative to a normalized U.S. government bond yield = 4.0% 2 ERP estimates derived from the present value discount rate of expected future income or dividends are equivalent to geometric averages of realized risk premiums. 3 ERP estimate derived from the survey cited is equivalent to geometric average of realized risk premiums.. 4 Survey response to expected return on S&P 500 over next 10 years of 5.46% minus 4.0% normalized 20-year U.S. government bond yield. 5 Recommended ERP based on default spread model and other factors. 59

60 Conditional ERP Estimates Reported in the 2014 Valuation Handbook Guide to Cost of Capital: Duff & Phelps Recommended ERP as of December 31, 2013 = 5.0% matched with an expected (normalized) riskfree rate = 4.0% 60

61 Size Effect Empirically observed: average returns on small firms greater than for large firms after adjusting for differences in beta (market risk) Two studies: CRSP Decile Size Premia measures size by market value of equity Risk Premium Report measures size by two market value based measures of size (equity and MVIC) plus six fundamental measures of company size Issues: Has size effect disappeared? Is size effect a proxy for other risks (e.g., variability of cash flows, lack of liquidity)? 61

62 Size Effect in U.S. Over Recent Time Periods Alternative Measures of Size Market Capitalization Risk Premium Report - Size Study: , SP SP Risk-free Rate (R f ) Security Market Line (SML) Sources of underlying data: 1.) CRSP U.S. Stock Database and CRSP U.S. Indices Database 2014 Center for Research in Security Prices (CRSP ), University of Chicago Booth School of Business. 2.) Morningstar EnCorr database. Used with permission. All rights reserved. Calculations performed by Duff & Phelps LLC. 62

63 Size Effect in U.S. Over Recent Time Periods Alternative Measures of Size 5-Year Average Net Income Risk Premium Report - Size Study: , SP SP Risk-free Rate (R f ) Security Market Line (SML) Sources of underlying data: 1.) CRSP U.S. Stock Database and CRSP U.S. Indices Database 2014 Center for Research in Security Prices (CRSP ), University of Chicago Booth School of Business. 2.) Morningstar EnCorr database. Used with permission. All rights reserved. Calculations performed by Duff & Phelps LLC. 63

64 Does the Size Effect Still Exist?(cont d) Difference in Return Over Period for All Possible Combinations of Start and End Dates CRSP Decile 10 (Small Stocks) Minus CRSP Decile 1 (Large Stocks): ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### ### 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