CHAPTER EIGHTEEN
The Analysis of Equity Risk and the Cost of Capital
Stephen H. Penman
The web page for this chapter runs under the following headings:
What this Chapter is Doing
Update of Shareholder Scorecard
Speculation About the Cost of Capital
Tail Risk
Upside and Downside Risk
Real Options
Pairs Trading
Scenario A and B Investing: Standing on Two Legs
Why Might Stock Prices Deviate from Fundamental Value? The Stuff of
Behavioral Finance
Attempts to Estimate the Equity Risk Premium
Reverse Engineering the Cost of Capital
What this Chapter is Doing
Chapter 18 shows how fundamentals are analyzed to indicate equity risk and the risk of
operations. It attempts to fill a gap in the book to this point: While the valuation formulas
presented incorporate the cost of capital, little indication has been given to how to
measure it. Indeed, while referring to standard techniques like the Capital Asset Pricing
Model (CAPM), the book has expressed some doubt about those techniques.
Unfortunately, the “state of the art” of measuring the cost of capital is incomplete, so the
chapter does not have a firm punch line: You will not find a method for determining a
percentage rate for the required return here. However, you will be able to develop profiles
that show how sensitive firms’ fundamentals – and their values  are to variation in
outcomes. The Valueat Risk analysis is at the heart of the chapter.
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View Full DocumentYou will also develop a better understanding of risk from this chapter so that, were you to
think about the rate of return you would require for a particular firm, you would have
some basis in doing so. The chapter outlines the fundamental determinants of risk, and
also distinguishes fundamental risk from price risk.
Update of Shareholder Scorecard
The Shareholder Scorecard, referred to in Table 18.1, is prepared annually by L.E.K
Consulting for the
Wall Street Journal
. Table 18.1 reports the top and bottom 2.5% of
firms on the Scorecard for 2004. The Scorecard for other years, including subsequent
years, can be viewed through the following website:
Speculation About the Cost of Capital
This book has repeatedly invoked the maxim: Don’t build speculation into a valuation.
The hesitancy in adopting standard “asset pricing” methods to measure the cost of capital
is due to this rule. While asset pricing models have the appearance of precision, they
involve considerable speculation.
Consider the CAPM:
Expected return = Riskfree return + (Beta × Market risk premium)
The only thing we know here, for sure, is the riskfree rate (provided we see US government
obligations as default free). The beta must be estimated, and techniques that estimate beta do
so with error. The market risk premium is a big guess, as explained in the Appendix to
Chapter 3 and in this Chapter 18; it really is very much a speculation. We have to be careful
in building this speculation into a valuation. See Box 13.3 in Chapter 13 for further
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 Spring '10
 johnathayeri
 Capital Asset Pricing Model, equity risk premium, fundamental value

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