Session 8: Estimating Hurdle Rates - Regression Betas

Summary

This session on corporate finance explores the concept of beta, a key factor in calculating the cost of equity and setting hurdle rates. Through a regression of stock returns against market returns, beta estimates the systematic risk of a company. The session emphasizes the importance of interpreting regression outputs, including Jensen's Alpha and R-squared, to assess stock performance. Practical examples, such as Disney, demonstrate how to calculate expected returns based on beta, market performance, and risk-free rates. The video highlights how understanding beta is crucial for making informed investment decisions and achieving higher returns than the hurdle rate.

Takeaways

• 😀 **Beta Estimation via Regression**: The conventional method for estimating a company's beta is by running a regression of stock returns against market index returns, with the slope representing the beta.
• 😀 **Jensen’s Alpha (Performance Measure)**: The intercept from the regression reflects the stock's performance compared to its expected return, after adjusting for market risk. This is called **Jensen’s Alpha**.
• 😀 **Risk Decomposition via R-squared**: The R-squared value from the regression tells you the percentage of the stock’s risk explained by the market, with the remainder being firm-specific risk.
• 😀 **Time Period and Data Frequency**: The choice of the time period (2-5 years) and the frequency of returns (monthly, weekly, or daily) affects the quality and accuracy of the regression beta estimate.
• 😀 **Dividends in Return Calculation**: When estimating returns, dividends should be included for the stock but can be ignored for the market index if necessary for simplicity in regression.
• 😀 **Market Index Selection**: A broad, market-cap-weighted index (like the S&P 500) is preferred for estimating beta because it approximates the market portfolio in the Capital Asset Pricing Model (CAPM).
• 😀 **Jensen’s Alpha Calculation**: Jensen’s Alpha measures how much a stock outperforms or underperforms relative to its expected return, adjusting for both market risk and actual market performance.
• 😀 **Beta Standard Error**: A regression beta is an estimate, and its accuracy is indicated by the standard error. A larger standard error means greater uncertainty in the beta estimate.
• 😀 **Cost of Equity Calculation**: The cost of equity is determined by adding the risk-free rate and the product of the beta and the equity risk premium, and this is used to assess required returns for investors.
• 😀 **Expected vs. Required Return**: The expected return from CAPM is the return an investor should expect from a stock based on its beta, while the required return is what investors need to earn to compensate for the risk of investing in that stock.
• 😀 **Practical Use of Beta and Jensen’s Alpha**: When assessing a company’s stock performance, comparing its Jensen’s Alpha to sector averages and understanding beta's range (via standard error) helps provide a more accurate picture of the stock's risk and return potential.

Q & A

What is the primary focus of the video script?

The primary focus of the video is on estimating beta using regression analysis, its limitations, and how to calculate the cost of equity and expected return for an investment.

What does beta represent in the context of the video?

Beta represents the risk of a stock relative to the market. A higher beta indicates that the stock is more volatile, while a lower beta indicates less volatility compared to the overall market.

Why is it important to look at the R-squared value in regression analysis?

The R-squared value indicates the proportion of the stock's risk that is explained by the market risk. A high R-squared means that the market is a significant factor in explaining the stock's risk, while a low R-squared suggests that other factors contribute more to the risk.

How does Jensen's Alpha help assess investment performance?

Jensen's Alpha measures the performance of an investment after adjusting for market risk. A positive alpha indicates that the investment has outperformed the market after accounting for its risk, while a negative alpha suggests underperformance.

What does the term 'cost of equity' refer to?

The cost of equity is the return that investors expect from an investment based on its risk. It includes the risk-free rate, the equity risk premium, and the stock's beta, and it serves as the hurdle rate for investment decisions.

How is the cost of equity calculated using the CAPM model?

The cost of equity is calculated using the Capital Asset Pricing Model (CAPM), which considers the risk-free rate, the equity risk premium, and the stock’s beta. The formula is: Cost of Equity = Risk-free Rate + Beta * (Market Return - Risk-free Rate).

What does a beta of 1.25 mean for a company's stock, like Disney?

A beta of 1.25 means that Disney’s stock is 25% more volatile than the market. If the market goes up or down by 1%, Disney’s stock is expected to change by 1.25% in the same direction.

Why should investors care about Jensen’s Alpha in addition to beta?

Investors should care about Jensen’s Alpha because it provides a measure of how well the investment has performed relative to its risk-adjusted return. It gives a clearer picture of a company's ability to generate returns above and beyond what the market would predict based on its risk (beta).

What does an R-squared value of 73% imply about Disney's stock risk?

An R-squared value of 73% implies that 73% of Disney's stock risk is explained by market movements, while the remaining 27% is attributable to factors specific to Disney, such as company performance or sector trends.

What would a negative Jensen’s Alpha indicate for an investor?

A negative Jensen's Alpha would indicate that the stock has underperformed relative to the expected return based on its risk. This suggests that the stock is not generating returns that justify its level of risk.