The Norwegian Market Risk Premium 2012 and 2013

Transcription

1 The Norwegian Market Risk Premium 2012 and 2013

2 Content 1. Introduction 3 2. Summary 4 3. Methodology and Sample Definitions and Approaches The Survey Sample 7 4. Survey Results Risk-free Rate in the Required Rate of Return Market Risk Premium Small Stock Premium Long-term Inflation Expectations Long-term Nominal Earnings Growth Investment Horizon The Impact of Ownership Structure on the Required Rate of Return Observable Market Risk Premium on the Oslo Stock Exchange (OBX) Approach and Assumptions Results Conclusion Methodology 19

3 1. Introduction PwC Deals has in collaboration with the Norwegian Society of Financial Analysts (NFF) for the second year in a row carried out a survey on the market risk premium, risk-free rate and small stock premium in the Norwegian market. The survey is based on responses from 224 of NFF s 1,150 members, which equals a 19% response rate. The survey was first conducted in Similar surveys have been conducted annually by, among others, PwC Sweden, since The purpose of this study is to obtain insight into the views on the size of the market risk premium, risk-free rate, small stock premium, long-term inflation and growth of earnings among players in the Norwegian market. The latter two topics are new as of this year. The survey respondents are analysts and economists with experience from the Norwegian financial and stock market. Their work includes investments, valuations and financial analysis and they provide advice to players in the Norwegian market - thus, their opinion of the various parameters may give an indication of the market s view on key figures in Norway. to a negative trend in the stock market. There is still unrest and high uncertainty associated with future economic conditions, making the issue still relevant. A focus on corporate governance makes it of particular interest to see whether the market over time changes its view on the importance of ownership structure in investment decisions. Both topics are therefore included in this year s survey. This year, we specifically looked at the long-term growth in the Norwegian market. Inflation in Norway has remained below the Central Bank s inflation target of 2.5% over a period of time, and interest rates have been at low levels. In his annual address on 16 February 2012, Central Bank Governor Øystein Olsen signalled that it may take several years before inflation in Norway is up to 2.5%. Thus, in this year s survey we ask; What should be applied as long-term (> 5 years) inflation in the Norwegian market? and What should be applied as long-term (> 5 years) nominal earnings growth in the Norwegian market using the Gordon growth model? The survey also includes an analysis of the observable market risk premium on the Oslo Stock Exchange. By taking the company values and consensus cash flow estimates, implicit rate of return and risk premium are estimated. Based on market data from 21 companies on OBX as of 14 November 2012, an implicit risk premium is estimated for the period 2010 to The intention is to supplement the survey each year with one or more current topics. The previous year s current issues were related to the investment horizon in shares and corporate governance. The reason for including this topic was the sovereign debt issues and high unemployment in parts of Europe and how it contributed 224 responses The survey is based on responses from 224 of NFF s 1,150 members, which equals a 19% response rate The Norwegian Market Risk Premium 2012 and

4 2. Summary Main findings are summarised as follows: The market risk premium in the Norwegian market is 5% for 2012 and The risk premium is unchanged from The 10-year government bond is mainly applied as risk-free rate in the Norwegian market. Several respondents note that the risk-free rate varies with the length of the underlying cash flow, thus the riskfree rate applied must be assessed from case to case. The majority of the players apply a small stock premium in the required rate of return for small companies. For companies with a market capitalisation above 2 billion there is general consensus among respondents when it comes to the size of the premium, while there is a greater dispersion in the response for companies with market capitalisation below 0.5 billion. There is no clear answer in terms of investment horizon for share investments, but most respondents (29%) are of the opinion that one should have an investment horizon of 4-6 years. A large proportion of the respondents (76%) are of the opinion that the ownership structure of a company affects the required rate of return of individual companies. Compared to last year s survey, this year s survey indicates that fewer respondents believe that risk decreases with government ownership. The median of expected inflation and nominal earnings growth is 2.5%. A high-level analysis of the observable risk premium on the Oslo Stock Exchange indicates a market risk premium of approximately 7%. Topic Main findings Response rate 4 The Norwegian Market Risk Premium 2012 and Main findings Market risk premium Median: 5.0% Median: 5.0% Weighted average 2012 and 2013: 5.0% Weighted average 2011 and 2012: 5.2% Response rate Risk-free rate 10-year government bond 44.3% 10-year government bond 43.5% 5-year government bond 19.9% 5-year government bond 20.5% Small stock premium Small stock premium applied 81.3% Small stock premium applied 77.1% Market capitalisation above 5 bn Median 0% Median 0% Market capitalisation 2-5 bn Median 0.0% - 1.0% Median 0.0% - 1.0% Market capitalisation 1-2 bn Median 1.0% - 2.0% Median 1.0% - 2.0% Market capitalisation bn Median 2.0% - 3.0% Median 2.0% - 3.0% Market capitalisation bn Median 3.0% - 4.0% Median 3.0% - 4.0% Market capitalisation bn Median 4.0% - 5.0% Median 3.0% - 4.0% Investment horizon Median: 4-6 years Median 6-8 years Weighted average: 7.2 years Weighted average: 7.5 years Ownership structure Required rate of return impacted 75.6% Required rate of return impacted 73.0% Government ownership No impact 55.5% No impact 56.5% Inflation Median: 2.5% Increases required rate of return 31.7% Increases required rate of return 21.2% Decreases required rate of return 12.8% Decreases required rate of return 22.3% Weighted average: 2.3% Earnings growth Median: 2.5% Observed market risk premium on the Oslo Stock Exhange Weighted average: 2.7% Median: 6.9%

5 3. Methodology and Sample 3.1. Definitions and Approaches In the following, key conceptual definitions and methodological assumptions are described. Risk-free rate Risk-free rate is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. Risk-free rate is in the study defined as the risk-free rate which should be applied in the required rate of return on equity for Norwegian companies. The required rate of return on equity (r e ) is given by the CAPM: r = r e f + β (r r where r f = risk-free rate, ß= beta, r m - r f = market risk premium. Market risk premium The market risk premium may refer to three different concepts 1) : 1. Required market risk premium: The incremental return of a diversified portfolio (the market) over the risk-free rate required by an investor. It is needed for calculating the required rate of return (CAPM). 2. Historical market risk premium: The historical excess return of the stock market over (risk-free) government bonds. 3. Expected market risk premium: The expected excess return of the stock market over (risk-free) government bonds. m f ) The long-term required market risk premium is applied in this survey (concept 1), defined as the difference between the cost of capital and the risk-free rate, which the respondent would have applied for the Oslo Stock Exchange in 2012 and There are two approaches commonly applied when studying the risk level in the equity market; measuring the premium ex post or ex ante. Measurement of risk ex post means in brief a comparison of the returns on capital investments in stock portfolios over longer periods of time, and returns on capital investment in risk-free instruments over longer periods of time. According to Dimson et al. (2006), the Norwegian annual market risk premium was 5.7% and 3.1% in the period 1900 to 2005 based on arithmetic and geometric mean, respectively. Risk premium studies ex ante are forward looking and based on market players expected or required return over the risk-free rate. Corresponding with the definition of market risk premium, an ex ante methodology is applied in this survey. One possible approach to the calculation of the market risk premium is to analyse the companies listed on the Oslo Stock Exchange. By taking the enterprise values and consensus cash flow estimates, implied required rate of return and risk premium can be estimated so that the present value of future earnings corresponds to the enterprise value. An overall analysis of the observable market risk premium based on this method is presented in Chapter 5. 1) Pablo Fernández, Market Risk Premium: Required, historical and expected, WP No 574, October 2004 The Norwegian Market Risk Premium 2012 and

6 Small stock premium A small stock premium is an addition to the required rate of return on equity as a result of small companies stocks historically being more volatile than larger companies and awarding investors with higher returns. Investors therefore warrant an additional premium. Small companies are also often associated with higher risk than larger companies due to factors such as greater dependence on key personnel, individual products or customers. Company size is defined in terms of market capitalisation. The survey maps whether respondents believe a small stock premium should be applied, as well as the size of the possible premium. Long-term inflation expectation Inflation is defined as the rate at which the general price level is rising. Inflation is usually measured by the consumer price index (CPI). In Norway, the operational target of monetary policy is the annual consumer price inflation close to 2.5 per cent over time. The monetary policy shall also contribute to stabilising output and employment. The survey maps the respondents expectations of long-term inflation in the Norwegian market. Long-term inflation expectation is in this study defined as the expectation of future inflation more than five years ahead. Long-term nominal earnings growth in the Gordon growth model The Gordon growth model assumes that the value of a future perpetual cash flow is equal to the present value of all future cash flows. The formula is often used to estimate a terminal value TV t, at a given time, t, where it is assumed that future annual cash flows, CF t, growing at an annual constant rate g. When the rate of return equals w, the relationship between value, cash flow, growth in cash flow and rate of return is expressed as follows: The formula can also be used to calculate the price of shares, assuming a cash flow of perpetual dividend payments that are growing at a constant annual nominal growth rate. The survey maps the nominal earnings growth respondents will apply when using the Gordon growth model. Long-term nominal earnings growth is in this study defined as the expectation of future earnings growth more than five years ahead. 6 The Norwegian Market Risk Premium 2012 and 2013

7 3.2. The Survey Sample The survey sample consists of the members of the Norwegian Society of Financial Analysts (NFF). NFF is a large Norwegian network of analysts and economists with experience from the Norwegian financial and stock market. The members of the network are market players who carry out analyses, valuations and provide financial advice to clients in the Norwegian market. Thus, they have high knowledge of the topics included in the survey and their opinion may give an indication of the market s view of key figures in the Norwegian market. The survey was sent to a total of 1,155 addresses, and in the period 1 November to 12 November 2012, we received 224 answers. This corresponds to a response rate of 19%. The respondents were asked in which of the following categories they work: banking, asset management, corporate finance, securities trading, private equity, accounting/auditing, financial advisory services or other. The results show that the highest proportion of respondents works within asset management (27%), while 20% work within the category other, see Figure 3.1. Several respondents in the category other state that they work in various financial or management positions such as CFO or controller. Some have also stated that they work within industries such as shipping and oil and gas, or with risk management and stock analysis. Figure 3.1: Respondents by business area Number Banking Asset Management Corporate Finance Securities trading The respondents were also asked whether they are working with investments, valuation or other tasks involving the use of required rate of return. A total of 196 (88%) responded that they are working with these types of tasks. The data has been crosschecked with this characteristic, and it is pointed out if the response from the respondents who do not work with required rate of return deviates from the remaining respondents answers. An interesting characteristic of the respondents is whether they base their answers on their own view or on their companies guidelines and policies when making statements about the various topics in the survey. 196 (88%) of the respondents base their answeres on their own view, while 12% have responded on the company s behalf, see Figure 3.2. This is close to an optimal distribution as the quality of the data is better when respondents answer based on their own qualified opinions and not by prescribed standards from the company they are working for. The data is also cross-checked with this respondent characteristic, and any differences will be commented on. Private Equity Work involves the use of required rate of return Work does not involve the use of required rate of return Accounting/Auditing 12% Own view Financial Advisory Services 88% Company view Other Figure 3.2: Respondent characteristic The Norwegian Market Risk Premium 2012 and

8 4. Survey Results 4.1. Risk-free Rate in the Required Rate of Return The respondents were asked what should be applied as the risk-free rate in the required rate of return on equity for Norwegian companies. The majority, 95 respondents (44%) are of the opinion that 10-year government bonds should be applied. 43 respondents (20%) apply 5-year government bonds, and 28 respondents (13%) apply the 3-month NIBOR. The results are almost identical as in the previous year s survey, see Figure % responded that they use other as risk-free rate. Several of these respondents have commented that they apply a risk-free rate that corresponds with the horizon of the underlying cash flow or that the risk-free rate is dependent on and varies with the type of business and risk exposure. Several state that they apply a 3-month Treasury bill, while others apply various swap rates, U.S. bonds, other interbank rates than NIBOR or combinations of fixed income securities with varying maturities. Some also comment that they would apply long-term bonds, but these are now at a lower level than the Norwegian central bank s (Norges Bank) inflation target which can imply a negative real interest rate. Issues related to negative real interest rates were also commented on by us in previous year s survey. Low interest rates can result in a risk-free interest rate that is lower than expected inflation. If estimating cash flow with terminal value and the required rate of return is based on an instrument with interest rates below the inflation expectation, implicitly one would get a negative risk-free interest rate in the terminal value. E.g. at 14 November 2012, a 10-year government bond implied a risk-free rate of 2.0%, which indicates a negative real interest rate with an inflation rate of 2.5%. Thus, different instruments may be applied as risk-free rate in the required rate of return in different periods to avoid the issue of negative real interest rate. Figure 4.1: Risk-free rate 50% 45% 40% 44% 44% 35% 30% 25% 20% 15% 10% 5% 0% 14% 13% 3-month interbank rate (NIBOR) 21% 20% 10% 9% 9% 10% 3% 5% 3-year govt bond 5-year govt bond 10-year govt bond Synthetic 30-year govt bond Other The majority, 95 respondents (44%), are of the opinion that 10-year government bonds should be applied as the risk-free rate in the required rate of return 8 The Norwegian Market Risk Premium 2012 and 2013

9 69 respondents, (32%), would apply a market premium of 5% for Market Risk Premium Figure 4.2 illustrates the respondents views on what they would apply as long-term market premium on the Oslo Stock Exchange in 2012 and 2013, defined as the difference between the required rate of return and risk-free rate. The majority of 69 respondents, (32%), would apply a market premium of 5% for The percentage is lower for 2013, with 29% responding they would apply a market premium of 5%. In the previous year s survey respondents were also asked what they would apply as a market risk premium for Figure 4.3 shows that a higher percentage believes that the risk premium for 2012 is 5.0% compared with last year. The views on the market risk premium for 2012 a year ago varied more among the respondents and a larger part assessed the premium to be 4.5%, 5.5% and 6.0%. The weighted average of the market risk premium is 5.0% for 2012 and 2013, see Table 4.4. The median also indicates a market risk premium of 5.0% for both years. Compared with 2011, there are no significant changes in the level of the market risk premium. The spread in the view on the market risk premium is shown in Figure 4.5. Figure 4.2: Market risk premium 2012 and % 30% 25% 20% 15% 10% 5% 0% <3.5% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0% 6.5% 7.0% 7.5% 8.0% >8.0% Figure 4.3: Market risk premium % 30% 25% 20% 15% 10% 5% 0% <3.5% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0% 6.5% 7.0% 7.5% 8.0% >8.0% 2012 survey 2011 survey Table 4.4 Market risk premium Weighted average 5.2% 5.0% 5.0% Median 5.0% 5.0% 5.0% Quartile 1 4.5% 4.0% 4.0% Quartile 3 6.0% 5.5% 5.5% The Norwegian Market Risk Premium 2012 and

10 A closer analysis of the view on the market risk premium among the respondents in the different industries show small differences (see Figure 4.6). A weighted average shows that all players would have applied a market premium of approximately 5%. Players in the banking sector and private equity would apply a slightly higher risk premium than the others, while players within securities trading are at a slightly lower level, although the differences are small. There are no significant differences in the level of market premium between respondents working with required rate of return and respondents who do not, or between respondents who answer on behalf of their own view or on behalf of their company. In May-June 2012 Fernandez et al. (2012) conducted an international survey on the size of the market risk premium used to calculate the required rate of return on equity. Thus, their definition of the premium corresponds with our definition of the market risk premium. The survey includes professors, analysts and management in various companies in 56 countries, thus addressed to a more extensive sample than our study. The number of responses for Norway is 58. Fernandez study indicates a higher risk premium in the Norwegian market, 5.8% and 5.5% based on the weighted average and median, respectively. See Table 4.7. Figur 4.5: Market risk premium - response spread 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Observations Figure 4.6: Average market risk premium % 5.4% 5.3% 5.2% 5.1% 5.0% 4.9% 4.8% 4.7% 4.6% 4.5% 5.4% Banking (24) 5.0% Asset Management (59) Corporate Finance (30) 5.1% Securities trading (24) 4.9% 5.3% Private Equity (11) 2013 Weighted average 2013 median 5.0% Accounting/Auditing (13) Number of respondents in each business area is given in parentheses in the figure 5.2% 5.0% Financial Advisory Services (16) Other (43) 10 The Norwegian Market Risk Premium 2012 and 2013

11 PwC Sweden conducts an annual survey on the market risk premium in the Swedish market. In 2011, the market premium was 4.5% based on the arithmetic mean and median, i.e. a slightly lower average than last year s result for the Norwegian market. However, this year s Swedish study indicates that the market risk premium for 2012 has increased compared with last year, see Figure 4.8. Responses imply a market risk premium in the Swedish stock market at 5.8% and 5.6%, based on the arithmetic mean and median, respectively. This is the highest measured level in the period and an increase of 1.2 and 1.0 percentage points compared to The Swedish study is based on 38 respondents. Table 4.7: Fernandéz et al (2012) Market risk premium 2011 and Country Average Median Number Average Median Number France 5.9% 6.0% % 6.0% 45 Sweden 5.9% 6.0% % 5.5% 38 Norway 5.8% 5.5% % 5.0% 30 USA 5.5% 5.4% % 5.0% Denmark 5.5% 5.0% % 4.5% 12 Finland 6.0% 6.0% % 4.7% 18 Germany 5.5% 5.0% % 5.0% 71 UK 5.5% 5.0% % 5.0% 930 Figure 4.8: Swedish market risk premium % 6.0% 5.4% 5.8% 5.0% 4.6% 4.3% 4.3% 4.5% 4.3% 4.9% 4.6% 4.5% 4.0% 3.0% 2.0% 1.0% 0.0% Jan 03 Feb 04 Feb 05 Jan 06 Feb 07 Feb 08 Feb 09 Mar 10 Mar 11 Mar 12 The Norwegian Market Risk Premium 2012 and

12 4.3. Small Stock Premium The survey maps whether respondents are of the opinion that a small stock premium should be applied in the required rate of return for small companies. 81% (178 respondents) applies such a premium, see Figure 4.9. In comparison, 77% answered that they apply a premium in the previous year s survey. One reason for using a small stock premium is that small companies may be associated with higher risk. Their future cash flows could be largely dependent on key personnel, individual products or customers. Small companies may also have difficulties getting financing. It is common practice to adjust for such factors, but there is different practice whether the increased risk is adjusted for in the cash flow directly or by a small stock premium or other premiums in the required rate of return. premium of 2-3% in the required rate of return, while companies with a market value of 0.1 to 0.5 billion should have a premium of 3-4%. These results correspond with what we saw in the previous year s survey. The only difference between the results for 2011 and 2012 is for companies with market capitalisation of 0 to 0.1 billion, with a median in 2012 of 4-5% versus 3-4% in Table 4.11 summarises the previous and current years weighted average and median small stock premium given the different ranges in market capitalisation. The respondents who answered that a small stock premium should not be applied in the required rate of return have the same view on the market risk premium as the rest of the respondents. Figure 4.9: Small stock premium 19% 81% Apply small stock premium Do not apply small stock premium Respondents who were of the opinion that a small stock premium should be applied in the required rate of return were asked to specify the percentage size of the premium given the market capitalisation of the company. Figure 4.10 shows the average small stock premium for companies of different sizes based on the median. Respondents who do not apply a small stock premium are not included in the results below. In line with expectations, the small stock premium increases the smaller the size of the company. Based on the median, a small stock premium should not be applied for companies with a market capitalisation above 5 billion. For companies with a market capitalisation of 2-5 billion, the median shows that a premium of 0-1% should be applied. For companies with market capitalisation of 0.5 to 1 billion, the study indicates a Based on the median, a small stock premium should not be applied for companies with a market capitalisation above 5 billion The size of the small stock premium is more volatile the smaller the size of the company 12 The Norwegian Market Risk Premium 2012 and 2013

13 81%, (178 respondents), are of the opinion that a small stock premium should be applied in the required rate of return for small companies The PwC survey conducted for the Swedish market indicates that the results in terms of small stock premium are relatively consistent. Approximately 84% in the Swedish study responded that they apply a small stock premium in the required rate of return. Average size of the small stock premium is shown in Table The weighted average premium for companies with market capitalisation above SEK 5 billion is set to 0.7% compared with 0.6% for companies with market capitalisation above NOK 5 billion. The small stock premium for Swedish companies with a market capitalisation of SEK 2 billion is estimated to 1.4% compared with 1.3% for Norwegian companies with market capitalisation between NOK 2 and 5 billion. The size of the premium for the smallest companies is higher for the Norwegian companies than the Swedish companies. Figure 4.10: Small stock premium - Median 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Table 4.11: Above 5 bn 2-5 bn 1-2 bn bn 0.1-0,5 bn bn Small stock premium Market capitalization Weighted average* Median Weighted average* Median Market capitalisation above NOK 5 bn 0.6% 0.0% 0.9% 0.0% Market capitalisation NOK 2-5 bn 1.3% 0% - 1% 1.5% 0% - 1% Market capitalisation NOK 1-2 bn 2.0% 1% - 2% 2.1% 1% - 2% Market capitalisation NOK bn 2.9% 2% - 3% 2.9% 2% - 3% Market capitalisation NOK bn 3.9% 3% - 4% 3.6% 3% - 4% Market capitalisation NOK bn 4.5% 4% - 5% 4.5% 3% - 4% *Weighted average is calculated as the center point of the interval. Table 4.12: Small stock premium - Sweden Feb 2007 Feb 2008 Feb 2009 Mar 2010 Mar 2011 Mar 2012 Market capitalisation SEK 5 bn 1.0% 0.6% 1.2% 0.7% 0.8% 0.7% Market capitalisation SEK 2 bn 1.3% 1.3% 1.6% 1.2% 1.4% 1.4% Market capitalisation SEK 0.5 bn 2.0% 2.5% 2.6% 2.2% 2.6% 2.6% Market capitalisation SEK 0.1 bn 3.1% 3.9% 3.9% 3.8% 3.8% 3.9% The Norwegian Market Risk Premium 2012 and

14 The volatility in the answers concerning the size of the small stock premium is larger the smaller the company is. The standard deviation is higher and there is less consistency in the answers for the smaller companies. Figures 4.13 to 4.15 show the response rate for the various small stock premiums for companies of different sizes. Over 50% of the respondents are of the opinion that the small stock premium is equal to 0 for companies with market capitalisation above 5 billion and 30% assess it to be between 0-1%; illustrated by a right-skewed distribution in Figure Figure 4.15 shows that 21% of respondents are of the opinion that the small stock premium is greater than 8% for the smallest companies, while 18% assess it to only 2-3%. The previous year s survey indicated 22% and 18% for the corresponding premiums for the smallest companies, respectively. Thus, there is a significant gap between the various respondents assessment of the correct small stock premium for companies with market capitalisation less than 0.5 billion. Figure 4.13: Market capitalisation above 5 bn and 2-5 bn 60% 50% 40% 30% 20% 10% 0% 0% 0%-1% 1%-2% 2%-3% 3%-4% 4%-5% 5%-6% 6%-7% 7%-8% >8.0% Above 5 mrd 2-5 bn Figure 4.14: Market capitalisation 1-2 bn and bn 40% 35% 30% 25% 20% 15% 10% 5% 0% 0% 0%-1% 1%-2% 2%-3% 3%-4% 4%-5% 5%-6% 6%-7% 7%-8% >8.0% 1-2 bn bn Figure 4.15: Market capitalisation bn and bn 30% 25% 20% 15% 10% 5% 0% 0% 0%-1% 1%-2% 2%-3% 3%-4% 4%-5% 5%-6% 6%-7% 7%-8% >8.0% bn bn 14 The Norwegian Market Risk Premium 2012 and 2013

15 4.4. Long-term Inflation Expectations The survey includes the respondents expectations to long-term inflation in the Norwegian market. Long-term is in this study defined as more than five years ahead. 45% of the respondents say they expect a long-term inflation rate of 2.5% in the Norwegian market, while 40% say they expect 2.0% inflation (see Figure 4.16). In his annual address, Central Bank Governor Olsen signaled that it may take several years before inflation in Norway reaches the inflation target of 2.5%. According to Olsen, this is due to assumption of low price growth for our trading partners for several more years. The key interest rate is already low, and further interest rate cuts to push up inflation may have several adverse effects on the Norwegian economy. According to the Monetary Policy Report 3/12, Norges Bank estimates that inflation will reach the target of 2.5% in In the past year, underlying inflation remained between 1.0% and 1.5%. The current low inflation, low interest rates and uncertain growth development with our trading partners can support that 40% of the respondents expect the long term inflation to be lower than Norges Bank s inflation target. Figure 4.16: Long-term inflation expectations 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% <0.5% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% >5.0% 45%of the respondents say they expect a long-term inflation rate of 2.5% The Norwegian Market Risk Premium 2012 and

16 The median indicates a long term nominal earnings growth of 2.5% 4-6 years The median indicates 4-6 years as an optimal investment horizon for shares 4.5. Long-term Nominal Earnings Growth The respondents were asked what should be applied as the nominal long-term earnings growth in the Norwegian market using the Gordon growth model. Longterm is in this study defined as more than five years ahead. Figure 4.17 shows that 31% of the respondents say they would apply 2.5% as long-term nominal growth, while 21% would apply 2.0%. 16% of the respondents would apply 3.0% earnings growth. 42 respondents did not answer this question. To some extent, the results correspond with inflation expectations presented in the previous section. 46% of respondents saying they expect 2.5% in long-term inflation also expect a nominal earnings growth of 2.5%. 42% of respondents who expect 2.5% inflation would expect a higher nominal earnings growth than 2.5%. The latter applies in general for the entire sample; e.g. 37% of respondents who expect 2.0% inflation expect 2.0% in nominal earnings growth, while 50% expect a higher nominal growth than 2.0%. Figure 4.17: Long-term nominal earnings growth 35% 30% 25% 20% 15% 10% 5% 0% <0.5% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% >5.0% Figure 4.18: Investment horizon for shares 35% 30% 25% 20% The results indicate that the perpetual cash flows valued/priced are expected to have a higher growth rate than the long-term inflation in the economy. Whether a company or a stock will have a higher or lower future growth than the underlying growth in the economy must be considered individually in each case. 15% 10% 5% 0% 0-2 years 2-4 years years 6-8 years 8-10 years years years Over 20 years 4.6. Investment Horizon Figure 4.18 indicates that there is considerable variation in respondents views on investment horizon for shares. A weighted average of the total sample provides an optimal horizon of 7.2 years, while the weighted average was slightly higher in last year s survey, with an average of 7.5 years. Part of the explanation for the lower average this year is given by a lower proportion responding years and over 20-years relative to the previous year s survey. This lowers the weighted average, despite the fact that a greater proportion of the respondents answer 8-10 years and a smaller proportion answer 6-8 years in this year s survey. Median optimal investment horizon is 4-6 years, which is lower than previous year s median of 6-8 years. 29 answer 4-6 years, while 24% answer that a horizon of 8-10 years will be optimal. 16 The Norwegian Market Risk Premium 2012 and 2013

17 4.7. The Impact of Ownership Structure on the Required Rate of Return As a result of increasing focus on corporate governance, it is interesting to see whether respondents are of the opinion that the ownership structure of individual companies impacts the required rate of return. 76%, 164 respondents believe that ownership structure impacts the required rate of return, see Figure This corresponds with the previous year s survey, in which 73% responded that the ownership structure impacts the required rate of return for individual companies. This is in line with what we would expect and one of the reasons for the increased focus on corporate governance. Figure 4.19: Ownership structure and impact on required rate of return 80% 70% 60% 50% 40% 30% 20% 10% 0 73% 76% Ownership structure impacts required rate of return % 24% Ownership structure does not impacts required rate of return The respondents were also asked whether government ownership impacts the required rate of return for individual companies. An increased required rate of return, all else being equal, decreases the value of the company. The results show that there are no clear views among the respondents in terms of this matter. As shown in Figure 4.20, 56% (121 respondents) state that government ownership will have no effect on the size of the required rate of return, 32% (69 respondents) state that government ownership leads to a higher required rate of return, while 13% is of the opinion that it decreases the required rate of return. Last year and just prior to the survey, there were several cases in media questioning the government s management of its ownership. Compared to 2011, the percentage share stating that government ownership does not impact the required rate of return, remains stable and below 60%. However, a smaller percentage of respondents answer that state ownership decreases the required rate of return. This indicates that fewer are of the opinion that risk decreases with Figure 4.20: Government ownership and impact on required rate of return 60% 50% 40% 30% 20% 10% 0 22% 21% 13% Decreases required rate of return government ownership. This is despite the ability and historic willingness of the government to assist with equity, loans and guarantees. 32% Increases required rate of return 57% 56% No impact The Norwegian Market Risk Premium 2012 and

18 5. Observable Market Risk Premium on the Oslo Stock Exchange (OBX) 5.1. Approach and Assumptions One possible approach to estimate the risk premium in the Norwegian market is to analyse the companies listed on the Oslo Stock Exchange. By taking the enterprise values and consensus cash flow estimates, the implied required rate of return and the risk premium can be estimated so that the present value of future earnings corresponds to the enterprise value. To conduct this exercise, assumptions are made for all the variables included in the company s required rate of return, so that the market risk premium is the residual in the calculation for each company. Risk-free interest rate, small stock premium and expected growth in the terminal period is based on the survey s results. To calculate the company s equity beta, 60 monthly observations measured against a global index have been applied. Each company s cost of debt is estimated based on credit ratings from S&P and Moody s, analyst reports and rating models Results Implied risk premium is estimated based on 21 companies on OBX on 14 November ). The data show a volatile median risk premium ranging from 5.4% in Q to 8.9% in Q As of Q3 2012, the median premium is 6.6%. Average median for the entire period is 6.9%, which is slightly higher than the results from the survey. The results are based on data for a relatively short period of time and a volatile stock market. There is great variation in the implied risk premiums calculated for each company over time, and there is a varying number of available analyst estimates for each company. No adjustments are made for company-specific risk in the required return on equity. The survey results indicate a median risk premium of 5%. If a risk premium of 5% is added to the analysis, the equity value of each company must increase if the present value of expected future earnings is to be equal to the enterprise value. The analysis indicates that a risk premium of 5% corresponds to a premium on observed market value of equity of approximately 35% for each company. Figure 5.1: Median implied market risk premium for the OBX list Q to Q % 8.5% 8.0% 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q Median Average median Year Total Average median 6.5% 7.2% 7.1% 6.9% 2) Banks and financial institutions DNB, Gjensidige Forsikring and Storebrand are excluded from the analysis 18 The Norwegian Market Risk Premium 2012 and 2013

19 5.3. Conclusion 5.4. Methodology The analysis indicates an average median risk premium of 6.9% for the period 2010 to Q3 2012, which is slightly higher than the results from the survey. If a risk premium of 5.0% is applied, this corresponds to a premium on the market value of equity of approximately 35% for each company. (1) (2) Assume that we analyze N companies from the OBX list on the Oslo Stock Exchange. Company i has enterprise value given by EV i and expected (consensus) cash flow estimate at time t given by CF it. The following formula expresses the relationship between the enterprise value for the company and future earnings: Where w i is the company s implied expected average cost of capital (WACC), T i denotes the total number of time periods with consensus estimates for a company i, and g is terminal growth rate (the Gordon growth model). WACC for company i is given by: Where r f is the risk-free rate, ß i is the company equity beta, and the expected market risk premium is defined as MRP i. The small stock premium and any other adjustment to the return on equity are given by respectively SSP i og α i. For cost of debt, the premium on risk-free rate is defined as ρ i. Equation (1) can be solved in order to find implied WACC based on observed enterprise values and cash flow estimates. Capital structure, risk-free rate, company risk (beta) and cost of debt can also be observed from available market data. Formula (2), together with formula (3) and (4), can be used to isolate the implied market risk premium based on data for company i as MRP i 3). The median risk premium for the OBX list is calculated based on the implied market risk premiums for each company. Where e i denotes the cost of equity and d i denotes the cost of debt. The capital structure is given by equity E i and debt D i. The tax rate s is assumed constant for all companies. The required rates on return can be defined as: (3) (4) 3) By solving WACC with respect to MRP i we get the following relationship: The Norwegian Market Risk Premium 2012 and

20 We would like to thank everyone who has contributed to the survey: ABG Sundal Collier ABN AMRO AdvicePartner Advokatfirma Rosen & Co Agilis Group Aker Aker Seafoods AksjeNorge Aktiv Kapital Alden Alfred Berg Kapitalforvaltning AmestoAccountHouse Arctic Paper Norge Arctic Securities Asker kommune Avocet Mining PLC og Douro Gold Aweco Invest Bama Beha Bolt Communicaton Bridgehead Vest AS BW Ventures BWAS Group CapMan Captiva Carnegie Castelar Corporate Finance CentraGruppen Cermaq Citigroup Connectum Capital Management Converto Capital Management Crux Kommunikasjon Danske Bank Danske Capital Danske Markets Delta Invest Det norske oljeselskap DHT Corporate Services DNB DNB Asset Management DNB Bank DNB Kapitalforvaltning DNB Markets EDB-konsulent Eidsiva Vannkraft Ernst & Young EuroMerger Norway Fearnley Finans Shipping Ferd Ferd Capital Finansco Finøk AS/AF Kommunepartner First First Securities Foinco / Altaria Folketrygdfondet Fondsfinans Fondsfinans Kapitalforvaltning Formuesforvaltning FSN Capital Gabler Wassum Gjensidige Gjensidige Forsikring Gjensidige Investeringsrådgivning Grant Thornton Grieg Investor Grieg Shipping Group Guardian Corporate Hafslund Handelsbanken Handelsbanken Capital Markets Handelsbanken Kaptialforvaltning Handelshøyskolen BI HCP Hegnar Media Hektor Hydro Kapitalforvaltning Høidahl & Solheim Industrifinans Capital Inocean Investinor Klaveness Marine KLP KLP Kapitalforvaltning KPMG KS-Holding Kverva LRB Holding Lyse Energi Meritorius Mustad Industrier NeoMed Management Nettbuss Nexia Nordea Nordea Bank Nordea Fondene Nordea Investment Management Nordea Markets Nordiske Investeringsbank NorgesGruppen Norne Securities Norscan Partners Northern Navigation Norway 20 The Norwegian Market Risk Premium 2012 and 2013

21 Norvestor Equity Norwegian Securities NRP Asset Management NRP Finans NTE Marked Nærings- og handelsdepartementet ODIN Forvaltning Optimum Orkdal Sparebank Orkla Oslo Finans Pangea Property Partners Pareto Bank Pareto Forvaltning Pareto Securities Pensjon & Finans Pharos Advisors Privat Eiendomsselskap Privatinvestor PwC Ravi as revisjon Revisjonsfirmaet Henning Grue Rokade RS Platou Markets Saga Corporate Finance Sandnes Sparebank SEB SEB Merchant Banking Selvaag Invest Skagen SMC SpareBank 1 SpareBank 1 Gruppen SpareBank 1 Markets SpareBank 1 Ringerike Hadeland SpareBank1 Livsforsikring SpareBank1 SMN Sparebanken Sogn og Fjordane Sparebanken Sør Sparebanken Vest SR-Investering Statkraft Statoil Statoil Kapitalforvaltning Stavseth shipping Steinvender Stenshagen Invest Storebrand Storebrand Kapitalforvaltning Subsea 7 Swedbank Taiga Fund Management Telenor Telenor Kapitalforvaltning Terra Markets Transvega Troms Kraft Trondheim kommunale pensjonskasse TrønderEnergi Umoe Restaurant Group UNIFOR UpSource Nordic Usbl Vind VJ Invest Warren Securities Wiersholm advokatfirma Østfold Energi Other individuals (private investors, retirees and students) The Norwegian Market Risk Premium 2012 and

22 About NFF The Norwegian Society of Financial Analysts was established in The association has just over members. The organisation arranges presentations, seminars, the AFA study, Interest and Asset Management courses, the Stockman Prize and contributes to different financial publications. The association s objective is to: Contribute to the general understanding of the function of the capital market and its importance to the Norwegian economy Promote good regulatory framework and an efficient capital market Contribute to analytical work of high standard and promote high ethical standards in financial analysis, asset management, consulting and sale of financial instruments Guri Angell-Hansen Mobile: guri.angell-hansen@finansanalytiker.no 22 The Norwegian Market Risk Premium 2012 and 2013

23 About PwC Deals PwC Deals regularly advises companies, owners and investors with business development, valuation services, execution of transaction processes (acquisitions, sales, divestments, mergers, LBOs, MBOs etc.) financial and commercial due diligence and financial modelling related to financing strategies. Additionally, we conduct strategic and financial analyses for our clients. Our services within financial modelling include assistance in the preparation of models for: Acquisitions and other strategic decisions Management reporting Capital requirements and financing Covenants and cash flow projections PwC Deals provides services related to the valuation of all or parts of the company, options, purchase price allocations, impairment tests, financial analysis and modelling. Our services in terms of valuations include: Valuation of companies and assets Intra-group transactions Purchase price allocations Impairment tests Interest assessment Incentive programs Fairness opinion Torbjörn Gärdehall Mobile: Tor Harald Johansen Mobile: The Norwegian Market Risk Premium 2012 and

24 2013 PwC. All rights reserved. In this context, PwC refers to PricewaterhouseCoopers AS, Advokatfirmaet PricewaterhouseCoopers AS, PricewaterhouseCoopers Accounting AS and PricewaterhouseCoopers Skatterådgivere AS which are member firms of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.