Session 7: Estimating Hurdle Rates - Implied ERP, Country Risk and Company Risk

Summary

In this session, the professor discusses a dynamic, forward-looking approach to estimating equity risk premiums, highlighting the challenges of relying on historical data. Using the example of the S&P 500 in 2013, the speaker demonstrates how to calculate an implied equity risk premium based on expected future cash flows and growth rates. The method incorporates country-specific risks by adjusting for local market conditions and ratings. The session also explores the volatility of equity risk premiums over time, emphasizing the importance of using updated, dynamic premiums for more accurate financial modeling.

Takeaways

• 😀 Historical equity risk premiums rely on past data, which may not be predictive of future market conditions.
• 📈 A dynamic, forward-looking approach to estimating equity risk premiums uses current data, including risk-free rates and growth rates.
• 💡 The implied equity risk premium is calculated by estimating the internal rate of return (IRR) that matches the present value of future cash flows to the current price of the stock index.
• 💰 The implied equity risk premium for the S&P 500 in November 2013 was 5.49%, compared to a historical premium of 4.20%. This shows the dynamic nature of market conditions.
• 🌍 Equity risk premiums for countries with AAA ratings (like Germany and Australia) are set equal to the US's premium, while riskier countries add an additional country-specific spread based on default risk.
• 🔍 To calculate country-specific equity risk premiums, a default spread is scaled up to estimate the additional country risk premium.
• 📊 For companies with global operations, like Disney, the equity risk premium is weighted based on revenue sources from different countries or regions.
• 🛠️ The equity risk premium for companies is calculated by considering the geographical breakdown of revenues, not just the country of incorporation.
• 📉 Implied equity risk premiums are volatile and can change significantly over short periods, as seen during the 2008 financial crisis when the premium surged from 4.37% to 8%.
• 🔄 The implied equity risk premium is regularly updated based on market conditions, with the 2014 update showing a decrease from 5.49% to 5.0% due to changes in expected cash flows and growth rates.
• ⚠️ Due to the volatility and dynamism of the market, historical equity risk premiums are less reliable, and forward-looking estimates are preferred for making investment decisions.

Q & A

What is the primary focus of the session in the video?

The session focuses on estimating forward-looking, dynamic equity risk premiums (ERPs), which provide a more up-to-date and responsive measure compared to historical ERPs or investor surveys.

How does the forward-looking dynamic equity risk premium differ from historical ERPs?

The forward-looking dynamic ERP is based on expected future cash flows, growth rates, and market conditions, which change over time. In contrast, historical ERPs are based on past data and tend to be static, not reflecting current market dynamics.

What method does the speaker use to estimate the implied equity risk premium for stocks?

The speaker estimates the implied ERP by solving for the discount rate (yield to maturity) that makes the present value of expected future cash flows equal to the current stock price.

What data is needed to calculate the forward-looking ERP, and how is it used?

To calculate the forward-looking ERP, the data required includes the stock price, the most recent cash flows, an expected growth rate for cash flows, and a risk-free rate. This data is used to project future cash flows, discount them back to present value, and then derive the implied ERP.

In the example from November 1st, 2013, what was the calculated implied equity risk premium for US stocks?

In November 1st, 2013, the implied equity risk premium for US stocks was 5.49%, calculated using a forward-looking dynamic method that takes into account expected cash flows, growth rates, and the risk-free rate.

How are equity risk premiums adjusted for countries with different risk profiles?

Equity risk premiums for countries with different risk profiles are adjusted by adding a country risk premium based on the country’s credit rating. For example, countries with AAA ratings are assigned the same ERP as the US, while riskier countries, such as Brazil and India, have higher ERPs due to their additional default spreads.

What was the approach used to calculate the equity risk premium for Disney, and why was it important?

The equity risk premium for Disney was calculated based on the company’s global revenue distribution, with 82% of revenues from the US and 18% from overseas. The ERP for Disney was weighted based on the countries where it operates, resulting in an overall ERP of 5.76%. This approach accounts for the company's international exposure, which is essential for accurate valuation.

What role does the risk-free rate play in estimating the equity risk premium?

The risk-free rate acts as a baseline for estimating the equity risk premium. It represents the return an investor would expect from a risk-free asset (such as a government bond) and is subtracted from the implied discount rate to derive the equity risk premium.

What happens to the implied equity risk premium during market crises, as demonstrated in the 2008 financial crisis?

During market crises, implied equity risk premiums can experience significant fluctuations, as market conditions and investor expectations change rapidly. For instance, in the last quarter of 2008, the implied ERP for the US nearly doubled from 4.37% to 8%, reflecting the heightened uncertainty and risk in the market.

How does the speaker suggest handling equity risk premiums for companies operating in multiple countries or regions?

For companies operating in multiple countries or regions, the speaker suggests calculating a weighted average of the equity risk premiums for each region or country where the company generates revenue. This approach ensures that the company’s global exposure is properly reflected in the risk premium.