Session 4: Equity Risk Premiums

Introduction to Equity Risk Premium

In this section, the speaker introduces the concept of equity risk premium and explains how it is used in valuation.

What is Equity Risk Premium?

• The equity risk premium is the premium an investor would demand over and above the risk-free rate for investing in risky assets such as equities.

• It is a number that can change over time and depends on an individual's risk aversion and perception of macroeconomic risks.

How to Estimate Equity Risk Premium?

• There are two basic ways to estimate equity risk premium: historical risk premium and forward-looking dynamic premium.

• Historical risk premium estimates look at past data to determine how much an investor would have made investing in stocks compared to something riskless like Treasury bonds.

• Forward-looking dynamic premiums take into account current market conditions and future expectations.

• When estimating a risk premium looking in the past, it's important to remember that it's a statistical estimate with a standard error.

Why is Equity Risk Premium Important?

• Every analyst, company, and consulting firm uses equity risk premiums in valuation.

• Estimating a reasonable equity risk premium is crucial for making informed investment decisions.

Estimating Equity Risk Premium

In this section, the speaker discusses the flaws of using a historical premium to estimate equity risk and proposes a forward-looking approach to estimating equity risk premium.

Historical Premium is Flawed

• Using historical premiums assumes that the most successful equity market for the next century can be predicted.

• A better measure would be to average out premiums across multiple markets.

• The crisis of 2008 should have shaken faith in things reverting back to historic norms.

Forward-Looking Approach

• To estimate forward-looking equity risk premium, compute an equivalent yield-to-maturity on a bond.

• Instead of buying a bond, assume you bought the S&P 500 at the start of 2013.

• Cash flows will take the form of dividends and buybacks.

• Estimate growth in earnings for the S&P 500 and project out expected growth in cash flows for the next five years.

• Use risk-free rate as proxy for when growth rate reverts back to economy's growth rate.

Implied Premiums

In this section, the speaker explains why implied premiums are important and how they can carry a message that investors ignore at their own peril.

Importance of Implied Premiums

• Ignoring implied premiums can lead investors to use too low or high premium estimates when valuing companies.

• Even if not used directly, it is important to know what implied premiums are at any point in time.

Estimating Equity Risk Premium in Emerging Markets

In this section, the speaker suggests ways to estimate equity risk premium in emerging markets where there is limited data available.

Using Default Spread

• Start with default spread for country and use it again to get equity risk premium.

• Look up standard deviation in local equity index.

• Use these two numbers to estimate equity risk premium.

Other Approaches

• Use a proxy market with similar characteristics to the emerging market.

• Estimate equity risk premium using a global model and adjust for country-specific risks.

Equity Risk Premium by Country

In this section, the speaker explains how to calculate equity risk premium for a country using either a rating-based default spread approach or an implied premium. The speaker also discusses how to develop a table of equity risk premiums by country.

Calculating Equity Risk Premium

• Use either the rating-based default spread approach or an implied premium to come up with risk premiums by country.

• To use the rating-based default spread approach, start with the mature market premium and add on the default spread for the country. If necessary, scale up the default spread for additional risk.

• To use an implied premium, get inputs such as cash flows and expected growth rate for both US and Brazil markets. Then use these inputs to calculate an implied premium for Brazil.

Developing a Table of Equity Risk Premiums

• Develop a table of equity risk premiums by country at the start of every year using either approach above.

• Start with a base premium (e.g., 5.8% based on implied premium for US). For mature markets, use this base premium; for other countries, add an additional premium based on their rating and default spread adjusted for additional risk.

Three Ways to Use Country Risk Premium

In this section, the speaker explains three ways to use country risk premiums in valuing companies.

Three Approaches

• Approach 1 - Add country risk premium onto mature market premium which is added onto the risk-free rate to come up with cost of equity for company valuation

• Approach 2 - Bring country risk premium into the brackets and multiply it by beta to come up with cost of equity for company valuation.

• Approach 3 - Break down the country risk premium separately from mature market premium and estimate how exposed your company is to that country risk.

Incorporating Country Risk in Valuation

In this section, the speaker explains how to incorporate country risk in valuing companies.

Lazy Way vs Sensible Way

• The lazy way is to assume that emerging market companies are exposed to country risk while developed market companies are not.

• The sensible way is to think about countries in the perspective of where you do business. For example, if you're Coca-Cola, you're exposed to country risk because you operate in a lot of emerging markets.

Example

• Use revenue-weighted average of the country risk premiums of all different countries that a company operates in when estimating its exposure to country risks.

• Even if a US company gets most of its revenues from developed markets, it can still be exposed to substantial amount of risks from emerging markets (e.g., Coca-Cola).

Risk Management Tools for Production Facilities

In this section, the speaker discusses risk management tools for production facilities and emphasizes the importance of separating country risk from all other risks.

Measuring a Company's Exposure to Country Risk

• The speaker suggests that companies should start thinking about ways to separate country risk from all other risks.

• He emphasizes the importance of measuring a company's exposure to country risk.

• The speaker suggests that equity risk premiums can be simple or messy and can be obtained by looking backwards.