Session 7: Estimating Hurdle Rates - Implied ERP, Country Risk and Company Risk
New Section
In this section, the speaker discusses a dynamic way of estimating equity risk premiums that focuses on forward-looking approaches rather than relying solely on historical data.
Estimating Equity Risk Premiums Dynamically
- Estimating the yield to maturity on a bond involves considering the bond's price, coupons, and face value. The yield to maturity represents the internal rate of return that equates the present value of cash flows to the bond's current price.
- Extending the bond approach to stocks involves calculating an implied equity risk premium. By analyzing stock prices, expected cash flows, and growth rates, one can derive an implied equity risk premium for stocks.
- To estimate future cash flows for stocks, one needs to determine expected growth rates. While historical data can inform past performance, projecting future cash flows requires assessing anticipated growth rates.
Implications of Dynamic Estimation
- Projecting cash flows for five years based on growth rates allows for a long-term assessment of returns. Beyond year five, assuming a stable growth rate aligning with the economy's pace provides insights into sustained returns.
- Calculating an implied equity risk premium in this manner yields a forward-looking dynamic figure that reflects market conditions at a given time. This approach contrasts with historical premiums and offers updated insights into potential returns.
Country Risk Premium Estimation
The speaker delves into estimating country risk premiums using a three-step process involving mature market premiums and adjustments based on country ratings and default spreads.
Three-Step Approach to Country Risk Premiums
- Initiating with a mature market premium as a base figure (e.g., 5.5%), countries with AAA ratings are considered mature markets and assigned this premium. Notably, countries like Germany or Australia fall under this category.
- For countries without AAA ratings, additional spreads are added to their equity risk premiums based on default spreads specific to each nation. By scaling up default spreads accordingly, unique country risk premiums are derived for each region.
Estimating Equity Risk Premiums
In this section, the speaker discusses the process of estimating equity risk premiums for countries and companies, using Disney as an example to illustrate the methodology.
Estimating Equity Risk Premium by Country
- Different countries have varying risk premiums.
- Calculating equity risk premium for a company involves considering its global operations.
- Revenue weights are used to estimate equity risk premiums for companies operating in multiple regions.
Implied Equity Risk Premium Dynamics
- Implied equity risk premiums are dynamic and forward-looking.
- Example of how implied premiums changed during the 2008 crisis highlights their volatility.
Historical Trends in Equity Risk Premiums
- Analysis of implied equity risk premiums from 1960 to 2013 shows historical trends in the US stock market.
- Notable events like the dot-com boom and the 2008 crisis impacted equity risk premiums significantly.
Global Estimates and Practical Application
- Updating global estimates of equity risk premiums is essential for valuation purposes.