Web3ch18 - CHAPTER EIGHTEEN The Analysis of Equity Risk and...

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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 Value-at Risk analysis is at the heart of the chapter.
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You 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 = Risk-free return + (Beta × Market risk premium) The only thing we know here, for sure, is the risk-free 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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Web3ch18 - CHAPTER EIGHTEEN The Analysis of Equity Risk and...

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