CFA Institute - Required Return on Equity

CFA Institute - Required Return on Equity - R e f res h er...

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Equity Investments Capital asset pricing model (CAPM), equilibrium return, beta estimation, multi- factor model, Fama French model (FFM), arbitrage pricing theory (APT), Pastor- Stambaugh model (PSM), LIQ factor, Burmeister, Roll and Ross model (BIRR), build up method, bond yield plus risk premium method, country spread model, country risk rating model THE REQUIRED RETURN ON EQUITY With means to estimate the equity risk premium in hand, the analyst can estimate the required return on the equity of a particular issuer. The choices include the following: the CAPM; a multifactor model such as the Fama–French or related models; and a build-up method, such as the bond yield plus risk premium method. 4.1 The Capital Asset Pricing Model The CAPM is an equation for required return that should hold in equilibrium (the condition in which supply equals demand) if the model’s assumptions are met; among the key assumptions are that investors are risk averse and that they make investment decisions based on the mean return and variance of returns of their total portfolio. The chief insight of the model is that investors evaluate the risk of an asset in terms of the asset’s contribution to the systematic risk of their total portfolio (systematic risk is risk that cannot be shed by portfolio diversification). Because the CAPM provides an economically grounded and relatively objective procedure for required return estimation, it has been widely used in valuation. The expression for the CAPM that is used in practice was given earlier as Equation 4: 1 4 R E F R E S H E R R E A D I N G 31 Section 4 of Return Concepts , by Pinto, CFA, et al., 2014 CFA Curriculum, Level 2, Volume 4, Reading 31. Equity Asset Valuation , Second Edition, by Jerald E. Pinto, CFA, Elaine Henry, CFA, Thomas R. Robinson, CFA, and John D. Stowe, CFA. Copyright © 2009 by CFA Institute. 1 Formally, the CAPM is E ( R i ) = R F + β i [ E ( R M )- R F ] where E ( R i ) is asset i ’s expected return in equilibrium given its beta, equal to its required return, R F is the risk-free rate of return, and E ( R M ) is the expected return on the market portfolio. In theory, the market portfolio is defined to include all risky assets held according to their market value weights. In typical practice when applying the CAPM to value equities, a broad equity index is used to represent the market portfolio and an estimate of the equity risk premium is used for E ( R M ) − R F .
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Refresher Reading Equity Investments 2 Required return on share Current expected risk-free retu i = rn Equity risk premium + ( ) β i For example, if the current expected risk-free return is 5 percent, the asset’s beta is 1.20, and the equity risk premium is 4.5 percent, then the asset’s required return is Required return on share 5 12 4 or 4 i = + ( ) = 0 0 0 0 045 0 10 10 . . . . . percent The asset’s beta measures its market or systematic risk, which in theory is the sensi- tivity of its returns to the returns on the “market portfolio” of risky assets. Concretely,
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