Return on Invested Capital and Competitive Advantage
Discount Rate Selection in Relation to Cash Flows
When discounting cash flows analysts should use the discount rate that is consistent with the type of cash flow being discounted. A cash flow to equity should be discounted at the required rate of return on equity. When a cash…
The Weighted Average Cost of Capital
A company’s cost of capital is the overall required rate of return of a company’s suppliers of capital, estimated using the company’s weighted average required rates of return for the different sources of capital. For a company with creditors and…
The Required Return on Equity: International Issues
There are two major issues when estimating the required return of equities in a global context: Exchange rates. Data and model issues in emerging markets. There are difficulties in the estimation of the required return and risk premium in emerging…
Strengths and Weaknesses of Methods for Estimating the Required Return
CAPM Strenghts and Weaknesses The CAPM is a simple and widely accepted method of estimating the cost of equity. Beta is readily obtainable for a wide range of securities and it can be estimated easily when not available. For individual…
Beta Estimation
Beta Estimation for a Public Company For public companies, beta is estimated through ordinary least squares (OLS) regression of the returns on a stock on the returns on the market. Beta estimates from such a regression are influenced by the…
The Capital Asset Pricing Model (CAPM), the Fama-French Model, and the Pastor-Stambaugh Model
The Capital Asset Pricing Model (CAPM) According to CAPM, investors evaluate the risk of assets based on the systematic risk they contribute to their total portfolio. The expected return on an asset is calculated as: $$\text{Required return on share }i=\text{Current…
The Equity Risk Premium
The equity risk premium (ERP) is the additional return (premium) required by investors for holding equities rather than risk-free assets. It is the difference between the required return on equities and the expected risk-free rate of return. $$\text{Required return on…
Return Concepts
Holding Period Return (HPR) The HPR is the return earned from investing in an asset for a specified period, and is given by: $$\text{r}=\frac{\text{D}_{\text{H}}}{\text{P}_{0}}+\frac{\text{P}_{\text{H}}-\text{P}_{0}}{\text{P}_{0}}=\frac{\text{D}_{\text{H}}+\text{P}_{\text{H}}}{\text{P}_{0}}-1$$ Where: \(\text{D}_{\text{H}}=\) Investment income, e.g., dividends. \(\text{P}_{\text{t}}=\) Share price at time \(t\). \(\text{P}_{0}=\) Share price at…
Issues in Model Selection and Interpretation
For a valuation model to be appropriate, it should have the following three characteristics. 1. Consistent with the Company’s Characteristics The selection of a good valuation model requires a good understanding of the business. This includes its assets and how…
