The equity risk premium reflects what investors expect to earn on equities, as a class, over and above the risk free rate. Implicit in that definition are two key points. The first is that the equity risk premium is a macro number that applies to all stocks. The second is that the equity risk premium is the receptacle, in intrinsic valuation, for all macro economic fears. In fact, I used the equity risk premium as my vehicle for talking about how economic crises (the US rating downgrade of last summer, the Greece default dance…)
On my web site, I update the equity risk premium for the S&P 500 every month, with my latest update of 6.17% on June 29, 2012. Even if you accept that estimate as a reasonable one for the US, there are many other estimation challenges. If you are valuing a Brazilian company, what equity risk premium would you use? What if you are valuing a multinational like Siemens or GE, with significant revenues in emerging markets, or an oil company with substantial reserves in Nigeria? More generally, in the face of globalization, valuing any company now requires an understanding of how best to evaluate country risk and convert into appropriate equity risk premiums. If you are working for a multinational, understanding how equity risk varies across countries is central to coming up with hurdle rates that vary across countries and lead to a fairer allocation of capital.
Should equity risk premiums vary across countries?
The question of whether equity risk premiums should be different for different countries, at first sight, looks like it has an obvious answer. Of course! After all, Venezuela, Russia and Greece are riskier countries to invest in than Switzerland, Germany or Canada and should have higher equity risk premiums. The answer, though, is not that simple. There are two scenarios where country risk will cease to matter and you will use the same equity risk premium for all companies, no matter which country they operate in. The first is if country risk is idiosyncratic, i.e., specific only to that country, with no spill over effects. If this is the case, diversifying geographically across countries should make this risk disappear in your portfolio, which can be accomplished by companies expanding their reaches across the globe (think Coca Cola or Nestle), or easier still, by investors holding geographically diversified portfolios. The second is to assume that all investors invest in global portfolios, in which case you could compute a global equity risk premium, capturing macro economic risks around the world, and estimate betas for individual companies against a global equity index.
Both assumptions are difficult to sustain. The assumption that country risk is diversifiable is built on the presumption that the correlation across countries is low and that there is no contagion effect. That may have been true in the 1980s but as investors and countries have globalized, the correlation across countries has risen. Put differently, country risk is no longer diversifiable and requires a risk premium to those exposed to it. The assumption that investors are global is more reachable now than two decades ago, but institutional restrictions (Indian and Chinese investors still cannot invest easily overseas) and investor behavior (there is a substantial home bias in portfolios, where investors over invest in their domestic markets) still stand in the way.
Bottom line: I think that equity risk premiums do vary across countries, with higher equity risk premiums applying to riskier countries. Applying the same equity risk premiums across companies will lead you to over value companies that have higher exposure to emerging markets.
How do you estimate equity risk premiums for different markets?
If you accept the premise that equity risk premiums should be different for different market, the question of how best to estimate these premiums follows. You cannot obtain these premiums using historical data, i.e., by looking at the premiums earned by stocks over riskless investments within each of the markets. Why not? First, there may be no riskless investments in many of these markets, either because governments may have default risk or because government bonds were not issued/traded over the period. Second, these markets are changing so much over the historical period in question that the historical premium you get over the period is not a predicted premium. Third, and more important, equity markets are volatile and the equity risk premiums over 20,30 or even 50 years of data have estimation errors that drown out the estimate.
Here are three alternatives that can be used to estimate the equity risk premiums for other markets:
A. Country default spreads: The simplest approach is to start with a mature market premium (say, 6% for the US), and then augment it by adding a country default spread for the country in question. That default spread can be estimated in one of three ways:
Equity Risk premium for Peru = 6% (21%/15%) = 8.4%
Country Risk premium for Peru = 8.4% -6% = 2.4%
While this approach has intuitive appeal, its weakness is that the equity market volatilities are as much a function of country risk as they are a measure of liquidity, with less liquid markets (which are often the most risky) having higher standard deviations. Here are my estimates for emerging markets as of January 2012.
C. Scaled Default Spread: In this approach, you combine the first two, by starting with the country default spread in approach 1 and then scaling it for relative volatility, but this time of the equity index in the country to the volatility of the government bond in that country. Again, using Peru as the example, assume that the standard deviation in the Peruvian government bond is 14% and that the standard deviation in Peruvian equities stays at 21%:
Default spread for Peru = 2.00% (using the rating)
Country risk premium for Peru = 2.00% (21%/14%) = 3.00%
Total equity risk premium for Peru = 9.00%
By staying within the same market for both volatilities, this approach is less susceptible than the prior one to liquidity variations across markets. The standard deviations can be noisy or difficult to estimate and I prefer to use a median value for the ratio across markets, rather than the ratio for any given market. (See my January 2012 update of equity to government bond volatilities.)
There is one other approach, where you are not dependent upon knowing the mature market premium, historical volatilities or default spreads. You can compute an implied premium for an emerging market, based upon the level of equity prices and expected cash flows. While this is what I do for the S&P 500 each month to get the implied premium for the US, it is far more difficult to use in emerging markets, because of data limitations.
Where do you use this equity risk premium?
Equity risk premiums come into play at every step in investing. At the asset allocation stage, where you determine how much of your portfolio you will be allocating to different asset classes (equity, fixed income, real assets) and to different geographical areas, you have to make judgements of which markets you are getting the best risk/return trade off and allocate more money to those markets.
Once you have made your asset allocation judgments, equity risk premiums come into play, when you value individual companies. In intrinsic or discounted cash flow valuation, you need the equity risk premium to get to a cost of equity and capital. The common approach, among many practitioners, is to attach an equity risk premium to a company, based upon its county of incorporation. Thus, when valuing Peruvian companies, you would use 9.00% as your equity risk premium, thus pushing up your cost of equity/capital and pushing down value, and when valuing US companies, you would use the 6% (mature market premium). I would suggest a more nuanced approach (which will take a little more work): compute an equity risk premium for a company that reflects a weighted average of the countries it operates in, with the weights being based upon an observable variable (revenues seem to work best). Thus, if you are valuing a company with 30% of its revenues in Peru (ERP =9%), 30% of its revenues in Venezuela (ERP =12%) and 40% of it revenues in the US (ERP =6%), you would use the following:
Weighted average equity risk premium = .30 (9%) + .30 (12%) + .40 (6%) = 8.7%
If the company breaks down revenues into regions rather than counties, you may have to compute a premium by region (Latin America, South Asia, Eastern Europe, Sub-Saharan Africa etc.) and take a weighted average.
In relative valuation, the use of country risk is usually implicit or qualitative. Thus, when comparing the PE ratios for oil companies, you may choose not to buy Lukoil, even though it trades at a lower PE than Conoci, because you worry about Russian country risk. If you want to be more explicit about how much to adjust multiples for country risk, download my spreadsheet for computing intrinsic multiples and change the equity risk premium to see how much PE or EV/EBITDA multiples change as the equity risk premium changes.
My latest update
I update country risk premiums, by country and region, at the start of every year. Given the turmoil of the last six months, and dramatic changes in country risk (especially in Europe), I have updated the numbers as of June 30, 2012. You can get the latest version of my estimates of country risk premiums by clicking here. If you want a blow-by-blow account of my reasoning on equity risk premiums, you can be a glutton for punishment and download my paper on equity equity risk premiums (the 2012 version).
On my web site, I update the equity risk premium for the S&P 500 every month, with my latest update of 6.17% on June 29, 2012. Even if you accept that estimate as a reasonable one for the US, there are many other estimation challenges. If you are valuing a Brazilian company, what equity risk premium would you use? What if you are valuing a multinational like Siemens or GE, with significant revenues in emerging markets, or an oil company with substantial reserves in Nigeria? More generally, in the face of globalization, valuing any company now requires an understanding of how best to evaluate country risk and convert into appropriate equity risk premiums. If you are working for a multinational, understanding how equity risk varies across countries is central to coming up with hurdle rates that vary across countries and lead to a fairer allocation of capital.
Should equity risk premiums vary across countries?
The question of whether equity risk premiums should be different for different countries, at first sight, looks like it has an obvious answer. Of course! After all, Venezuela, Russia and Greece are riskier countries to invest in than Switzerland, Germany or Canada and should have higher equity risk premiums. The answer, though, is not that simple. There are two scenarios where country risk will cease to matter and you will use the same equity risk premium for all companies, no matter which country they operate in. The first is if country risk is idiosyncratic, i.e., specific only to that country, with no spill over effects. If this is the case, diversifying geographically across countries should make this risk disappear in your portfolio, which can be accomplished by companies expanding their reaches across the globe (think Coca Cola or Nestle), or easier still, by investors holding geographically diversified portfolios. The second is to assume that all investors invest in global portfolios, in which case you could compute a global equity risk premium, capturing macro economic risks around the world, and estimate betas for individual companies against a global equity index.
Both assumptions are difficult to sustain. The assumption that country risk is diversifiable is built on the presumption that the correlation across countries is low and that there is no contagion effect. That may have been true in the 1980s but as investors and countries have globalized, the correlation across countries has risen. Put differently, country risk is no longer diversifiable and requires a risk premium to those exposed to it. The assumption that investors are global is more reachable now than two decades ago, but institutional restrictions (Indian and Chinese investors still cannot invest easily overseas) and investor behavior (there is a substantial home bias in portfolios, where investors over invest in their domestic markets) still stand in the way.
Bottom line: I think that equity risk premiums do vary across countries, with higher equity risk premiums applying to riskier countries. Applying the same equity risk premiums across companies will lead you to over value companies that have higher exposure to emerging markets.
How do you estimate equity risk premiums for different markets?
If you accept the premise that equity risk premiums should be different for different market, the question of how best to estimate these premiums follows. You cannot obtain these premiums using historical data, i.e., by looking at the premiums earned by stocks over riskless investments within each of the markets. Why not? First, there may be no riskless investments in many of these markets, either because governments may have default risk or because government bonds were not issued/traded over the period. Second, these markets are changing so much over the historical period in question that the historical premium you get over the period is not a predicted premium. Third, and more important, equity markets are volatile and the equity risk premiums over 20,30 or even 50 years of data have estimation errors that drown out the estimate.
Here are three alternatives that can be used to estimate the equity risk premiums for other markets:
A. Country default spreads: The simplest approach is to start with a mature market premium (say, 6% for the US), and then augment it by adding a country default spread for the country in question. That default spread can be estimated in one of three ways:
- Government bonds in US$/ Euros: If the country in question has dollar or Euro denominated bonds, you can estimate the spread over the US treasury bond or the German ten-year bond rate respectively.
- Sovereign rating: Moody’s, S&P and Fitch all assign sovereign ratings to countries. You can estimate a typical default spread, based on the sovereign rating, using a lookup table that I update at the start of each year. Using Peru as an example, the sovereign rating of Baa3 for the country yields a default spread of 2.00%. Here are the latest local currency and foreign currency sovereign ratings from Moody's.
- CDS spreads: The Credit Default Swap market is of more recent origin, but it is a market that allows you to buy insurance against default risk (see my earlier post on this market). Thus, if you bought a 10-year Peruvian government bond with an interest rate of 4.5%, and were concerned about default, you could have bought a 10-year Peruvian CDS. The price of that CDS in June 2012 was 2.06%, effectively implying that you would need to pay 2.06% out of your 4.5% each year for the next 10 years to get default protection. If you are interested, here are the ten-year CDS spreads for all of the countries where they are offered as of June 30, 2012.
Equity Risk premium for Peru = 6% (21%/15%) = 8.4%
Country Risk premium for Peru = 8.4% -6% = 2.4%
While this approach has intuitive appeal, its weakness is that the equity market volatilities are as much a function of country risk as they are a measure of liquidity, with less liquid markets (which are often the most risky) having higher standard deviations. Here are my estimates for emerging markets as of January 2012.
C. Scaled Default Spread: In this approach, you combine the first two, by starting with the country default spread in approach 1 and then scaling it for relative volatility, but this time of the equity index in the country to the volatility of the government bond in that country. Again, using Peru as the example, assume that the standard deviation in the Peruvian government bond is 14% and that the standard deviation in Peruvian equities stays at 21%:
Default spread for Peru = 2.00% (using the rating)
Country risk premium for Peru = 2.00% (21%/14%) = 3.00%
Total equity risk premium for Peru = 9.00%
By staying within the same market for both volatilities, this approach is less susceptible than the prior one to liquidity variations across markets. The standard deviations can be noisy or difficult to estimate and I prefer to use a median value for the ratio across markets, rather than the ratio for any given market. (See my January 2012 update of equity to government bond volatilities.)
There is one other approach, where you are not dependent upon knowing the mature market premium, historical volatilities or default spreads. You can compute an implied premium for an emerging market, based upon the level of equity prices and expected cash flows. While this is what I do for the S&P 500 each month to get the implied premium for the US, it is far more difficult to use in emerging markets, because of data limitations.
Where do you use this equity risk premium?
Equity risk premiums come into play at every step in investing. At the asset allocation stage, where you determine how much of your portfolio you will be allocating to different asset classes (equity, fixed income, real assets) and to different geographical areas, you have to make judgements of which markets you are getting the best risk/return trade off and allocate more money to those markets.
Once you have made your asset allocation judgments, equity risk premiums come into play, when you value individual companies. In intrinsic or discounted cash flow valuation, you need the equity risk premium to get to a cost of equity and capital. The common approach, among many practitioners, is to attach an equity risk premium to a company, based upon its county of incorporation. Thus, when valuing Peruvian companies, you would use 9.00% as your equity risk premium, thus pushing up your cost of equity/capital and pushing down value, and when valuing US companies, you would use the 6% (mature market premium). I would suggest a more nuanced approach (which will take a little more work): compute an equity risk premium for a company that reflects a weighted average of the countries it operates in, with the weights being based upon an observable variable (revenues seem to work best). Thus, if you are valuing a company with 30% of its revenues in Peru (ERP =9%), 30% of its revenues in Venezuela (ERP =12%) and 40% of it revenues in the US (ERP =6%), you would use the following:
Weighted average equity risk premium = .30 (9%) + .30 (12%) + .40 (6%) = 8.7%
If the company breaks down revenues into regions rather than counties, you may have to compute a premium by region (Latin America, South Asia, Eastern Europe, Sub-Saharan Africa etc.) and take a weighted average.
In relative valuation, the use of country risk is usually implicit or qualitative. Thus, when comparing the PE ratios for oil companies, you may choose not to buy Lukoil, even though it trades at a lower PE than Conoci, because you worry about Russian country risk. If you want to be more explicit about how much to adjust multiples for country risk, download my spreadsheet for computing intrinsic multiples and change the equity risk premium to see how much PE or EV/EBITDA multiples change as the equity risk premium changes.
My latest update
I update country risk premiums, by country and region, at the start of every year. Given the turmoil of the last six months, and dramatic changes in country risk (especially in Europe), I have updated the numbers as of June 30, 2012. You can get the latest version of my estimates of country risk premiums by clicking here. If you want a blow-by-blow account of my reasoning on equity risk premiums, you can be a glutton for punishment and download my paper on equity equity risk premiums (the 2012 version).
I really don't understand why a person would use the ERP for Peru to value individual stocks in Peru. It makes sense to use a Peruvian ERP to value the broad Peruvian markets. But why should the same ERP apply to a Peruvian company with earnings, earnings growth & price volatility which are stable relative to another Peruvian company. I would have thought adjusting the Country ERP using something along the lines of Relative Equity Volatility (Volatility of Stock Vs Volatility of Country Market) would give a better and more stock specific ERP.
ReplyDeleteThe company's risk is measured by its beta. The cost of equity is a function of that beta and the equity risk premium. So, a company with more stable earnings will have a lower beta....
ReplyDeleteDear Prof,
ReplyDeleteSorry if the answer to this might be given in the paper. Is the ERP a figure that a company might use as a pension rate ?
In other words, while going through a 10K, if I see a Company confidently asserting that they are expecting a high pension rate of return (thereby attempting to make their earnings look good), I could compare it against a Equity Risk Premium figure I calculate and instantly know if it's out of whack, couldn't I ?
Thank you for all your posts.
As a follow-up, in the current environment where falsehood is the norm (and I expect it to get worse), it would be invaluable to learn from you, ways and means to dig out the value of companies after discounting, refuting and in the small number of cases corroborating Companies' versions of their value.
ReplyDeleteDear Aswath,
ReplyDeleteThis is something that is bugging me for a while- one of the traditional risk measures is a standard deviation. You are also scaling up the default spreads for a given country by relative volatility (SD of equities by SD of bonds). Which by default means that a market that is experiencing only positive spikes in equity prices will have an elevated standard deviation and as such will have higher equity risk premium attached to it. Shouldn't we be looking only at negative (downside) semivariance as a risk measure instead of traditional standard deviation? I guess my question is a sort of Sharpe vs Sortino type of dilemma... Thank you for your posts.
Regards,
Krystian
On the pension rate question, it is absolutely central. When a company (or a state government) claims that it can earn a certain expected return on stocks, it is assuming an equity risk premium. The incentive is to claim a high expected return so that you can set aside less.
ReplyDeleteOn the semi-variance issue, it turns out to be a tempest in a teapot. The variance measures the variability around the expected return; if a stock does really well over a period, the expected return will rise to reflect it. The semi variance is so highly correlated with the variance that it is almost irrelevant which one you use. There is the question of symmetry. If you believe that returns are skewed, you may want to consider the skewness in the distribution.
ReplyDeleteEquitry are a good way to build an investment but it is risky. You have to be careful and you have to be willing to really put yourself on the line.
ReplyDeleteDear Prof,
ReplyDeleteGreat article as usual!
I have one question regarding CAPM and the ERP.
When calculating cost of equity, would you apply:
1. Ce = Rf + B x (ERP + country premium)
or
2. Ce = Rf + B X ERP + country premium
A colleague of mine advocates approach 2, while I think 1 is better.
professor, If I use Black Scholes on option for foreign stocks, should I use the US risk free rate?
ReplyDeleteOn a related note- When I'm, using BS model to value options on stocks, Shouldn't I use cost of equity as the risk free rate? Doesn't it make more sense than using a risk free 1.6%?
I tried to calculate Equity risk premium using the implied equity risk premium formula for Indian market. I used both Sensex and BSE 500 but the ERP I am getting is about 19%. This happens due to many companies having negative FCFE. Whats the solution?
ReplyDeleteI was just wondering which fund one should use as a proxy for the euro risk free rate? I understand it should be German bunds, but I can't find an appropriate index fund.
ReplyDeleteWhen you calculate the average rate for a region would it not be more meaningful to weight the average by the relative GDP of each component country.
ReplyDeleteContrarian Individual Investor,
ReplyDeleteYou are right. I am going to weight based upon GDP or market cap of each country.
As for the ERP for India, a negative FCFE should give you a very low or negative ERP, not a very high ERP. And Indian companies collectively have negative FCFE? I find that difficult to reconcile with increasing cash balances at these companies.
Hello Professor,
ReplyDeletePlease excuse if my question is silly but I can nowhere see the effect of currency fluctuations.
For example, even if I invest in India and get returns above the ERP, it wont be much useful if my currency has appreciated against Indian rupee.
Can you please explain how we should take this into account?
Thanks
Rohit
Exchange rate risk gives and it takes away. if you have a global portfolio, exchange rate risk is the least of your worries.
ReplyDeleteThe equity risk premium reflects what investors expect to earn on equities, as a class, over and above the risk free rate
ReplyDeletesalt lake city attorney
Dear Prof,
ReplyDeleteWould we not be double-counting the default spread of a country when we multiply it by a multiplier (1.5) for std. deviation ? which means that the default spread (either obtained from ratings/cds) , should have already factored this parameter. Pl clarify .
Ankush
Dear professoer, the above paper is very useful. In your above example where you weight the different ERP's, do these ERP's also include the country risk premiums? Therefore is the Peru ERP of 9 percent composed of 6 percent ERP of US and 3 percent CRP? The reason for asking this question is that after taking the weighted averages we do not then need to add on a separate CRP at the end right?
ReplyDeleteThe ERPs do include the CRPs. Once you use the ERP, you don't need to adjust for country risk.
ReplyDeleteI agree with you. You have given us a great deal of information. Excellent work you have done for sharing with everyone
ReplyDeleteThanks for sharing. i really appreciate it that you shared with us such a informative post..
http://globalizatione.com/
If a company has 90% of its sales from exports, should i consider the Country risk of those countries in a proportion and or should i still the base country in which the country is located in?
ReplyDeleteI would consider both where you get your revenues and where you have your operations.
ReplyDeleteProfessor,
ReplyDeleteValuation - query:
When there are cross-holdings (say majority control), you require full consolidation.
Here when we look at capital employed we should take Equity + Debt - Cash - Minority interest in balance sheet. Is that correct? This is because the assets and liabilities are at their full consolidation values.
For earnings computation, we should be taking EBIT (1-t) - Minority interest share in income statement.
Can you please confirm?
Nope. That will not work. You have to add the minority interest to your equity to get to the full equity in the combined company and use the full operating income in the numerator. If you want just the parent company ROIC, you have to take out your majority stake from the equity in the invested capital and use only the parent's operating income.
ReplyDeleteok thanks professor.
ReplyDeleteBut if we use the full operating income of the combined company, the result would be valuation of the combined company. We have to remove minority stake in the subsidiary to get to equity valuation of the parent. For this we have to value the subsidiary separately. If there are several subsidiaries it would be a pain (additional pain if they are not listed).
Alternatively, is there a way to value the parent equity without getting to value the subsidiary separately?
I find that a large number of companies we see have operating subsidiaries / joint ventures in someway or the other.
I am a bit confused about whether to 1) use parent company's standalone numbers, value the parent and add value of parent's stake in subsidiaries/jv
OR 2)use consolidated financials and value the combined company and deduct minority holdings.
Please let me know which method works better and is preferable.
If you want just the parent company, you have to use the parent company financials (for debt, equity & cash). If you don't have parent company financials, things get messier.
ReplyDeleteyes thanks prof.
ReplyDeleteDear Professor,
ReplyDeleteI'm trying to understand a lot of tasks from your website. Please could you make a comment. I have found such problem in your textbook:
Alloy Mills is a textile firm that is currently reporting after-tax operating income of $100 million. The firm has a return on capital currently of 20% and reinvests 50% of its earnings back into the firm, giving it an expected growth rate of 10% for the next 5 years:
Expected Growth rate = 20% * 50% = 10%
After year 5, the growth rate is expected to drop to 5% and the return on capital is expected to stay at 20%. The terminal value can be estimated as follows:
Expected operating income in year 6 = 100*(1.10)5(1.05) = $169.10 million
Expected reinvestment rate from year 5 = g/ROIC = 5%/20% = 25%
Terminal value in year 5 = (169.10*(1-0,25))/(0.10-0.05) = $ 2,537 million
The value of the firm today would then be:
Value of firm today =
(55$/1,10)+(60.5$/1.10*1.10)+(66.55$/1.10*1.10*1.10)+(73.21$/1.10*1.10*1.10*1.10)+((80.53$+2.537$)/1.10*1.10*1.10*1.10*1.10)=1825$
My question is. Why is cash flow equal 80.53$ in year 5? As mentioned above "after year 5, the growth rate is expected to drop to 5% and the return on capital is expected to stay at 20%". Consequently reinvestment rate from year 5 is equal to 25%. Consequently cash flow should be equal to (100$*1,1^5)*0,75=120.78$
But not (100$*1,1^5)*0,50=80.53$
Thank you in advance!
Dear Professor,
ReplyDeleteThe question which is related to my previous comment. Please could you explain. Which reinvestment rate should we use in final year of period high growth?
- Reinvestment rate which is based on growth rate and Return on capital in high growth period
- Reinvestment rate which is based on growth rate and Return on capital in stable period
I think that reinvestment rate which is based on growth rate and Return on capital in stable period. But in this case FCFF should be higher in final year of period high growth. Is it right?
Hi Anonymous
ReplyDeleteI think fcff would look like this:
ebit (1-t)invst fcff
0)100.00 50% 50.00
1)110.00 50% 55.00
2)121.00 50% 60.50
3)133.10 50% 66.55
4)146.41 50% 73.21
5)161.05 50% 80.53
6)169.10 75% 126.83
So terminal year fcff would be 126.83.
Prof. can guide if this is incorrect.
In the terminal year - we use stable growth rate (equal to economy growth rate)and industry-average roc translating into stable reinvestment rate (which is lower).
ReplyDeleteIn high-growth period - we use high growth rate, higher reinvestment rate translating into above average roc.
Let's hear from prof. as well.
The problem highlights one of the short cuts that we use in DCF valuation (which I chose not to use in this problem) and here is what it is. The equation:
ReplyDeleteg = ROC * Reinvestment rate
is really one for getting the growth rate next year. Thus, the reinvestment rate in year 1 is 50% to give you the growth rate of 10% in year 2. Using this logic, the reinvestment rate in year 5 will drop to 25% in anticipation of growth in year 6 dropping to 5%.
I know that I do not do this consistently in my spreadsheets and valuations because the effect on value is fairly small but it is really the right thing to do.
Dear Professor!
ReplyDeleteThank you a lot!!! Your answer has an invaluable meaning for me!! For further learning your textbook and other materials!
I cordially ask you to answer the last question by this theme. Let's assume that company started own activity at the beginning 2011. Also company earned after-tax operating income 10 000$ during 2011. Reinvestment rate is equal to 40%. ROIC is equal to 15%. Consequently growth is equal to 0,15*0,40 = 6%.
My question is: FCFF in 2011 will be 10 000$ * (1-0,4) = 6 000$. I mean that company will be make an investments in the year in which after-tax operating income was obtained. Is it right?
I have another point of view. Maybe company should be make an investments at the beginning of 2012 (next year). In this case FCFF in 2011 will be 10 000$. And FCFF in 2012 will be 10 000$*1,06 - 4 000$ (reinvestments) = 6 600 $. Thus we see dropping of FCFF in 2012 comparing with 2011.
Dear Professor! Could you comment and thus help me. Which point of view is correct?
Hi Prof. Damodaran
ReplyDeleteFormer student here, now working at a mutual fund. I have looked at quite a few Asian companies and come across instances of value destruction when companies spend money on a) unnecessary (i.e. non-core) acquisitions b) conglomerates buying money sucking assets after years of stable, sensible acquisitions c) an indian co where the CEO bought a private jet (as an asset held for investment!) etc. Have you written anything on the psychology of such CEOs, or come across papers/articles on the topic. I find it fascinating how you can look at these and draw a complete blank when you look for the motivation behind such an acquisition. Why doesn't someone with the firm ask these questions, in other words, how are such events allowed to occur?
Also, thank you for your classes, it's quite heartening to see your textbook floating around the office!
I've wondered about these questions too and wandering through various avenues, these answers seemed to stand out:
ReplyDeletea) Why unnecessary (i.e. non-core) acquisitions ?
b) conglomerates buying money sucking assets after years of stable, sensible acquisitions
Some possible reasons (all cynical because that imo is the best and even a necessary lens to have on when uncovering true value):
a1) To artificially boost earnings: By writing off large chunks of the acquired company thus reducing future depreciation charges and thus boosting future earnings
a2) Strong delusion of Management that they can turn around existing money-suckers and integrate them well into their own company.
a3) Enthusiasm of M&A Banks and analysts propagating their agenda (the Prof. mentioned this unbelievable case of a company going to one of the top M&A banks and telling them they had x billion dollars to spend and would they (the bank) find them a suitable marriage alliance for that much. Of course, the bank will find and actively push for mergers.
c) an indian co where the CEO bought a private jet (as an asset held for investment!) etc.
Sheer greed and the knowledge that in a comparatively non-transparent market like the Indian (by this I mean, few activist investors and where company heads wield more absolute power because of board cronyism)
Just wanted to share some lines from the 2012 10K of SuperVal recently in the news for falling off the cliff via a 49% decline in share price!.
ReplyDeleteI was interested in the equity risk premium they assumed compared with what the Professor computed. Unless this is normal, it seems like a red flag that they are inflating the rate to set aside less as the Prof. mentioned earlier.
"The Company reviews and selects the discount rate to be used in connection with its pension and other post-retirement obligations annually.
The 10-year annual average rate of return on pension assets for fiscal 2012 and fiscal 2011 are lower than the assumed long-term rate of return of 7.5 and 7.75 percent due to the unprecedented decline in the economy and the credit market turmoil during fiscal 2008 and 2009.
The 10 year rolling average annualized return for investments made in a manner consistent with our target allocations have generated average returns of approximately 8.2% based on returns from 1990 to 2011. The Company expects that the markets will recover to the assumed long-term rate of return."
Good day,
ReplyDeleteMusings on Markets
Nice style! Good to see a talent at work. This has been really inspiring, thanks a lot!
Firs of al thank you very much, your work shortens the distance of world education.
ReplyDeleteI read comments, and I couldn t understand how could you take the proportion of Country Risk between the country of operation and the countries of sales (for example in a company with almost 100% exports).
Thanks Again.
I'm not sure I follow some of the assumptions. Couldn't one assume that each country does feel the "spill over" effects from the global market, and contemporaneously advocate for a lower ERP in some emerging markets. For instance, couldn't Peru feel the effects of a meltdown in Europe, but have a LOWER ERP than the US due to the fact that even though it is not completely insulated from spill over, is still more insulated than the US? Thanks for taking the time to respond to all of these questions.
ReplyDeleteprof. your website is not connecting - any particular reason?
ReplyDeleteThe NYU servers are down for maintenance this weekend.
ReplyDeletethank you prof.
ReplyDeleteDear Professor!
ReplyDeleteI'm sorry to bother you again!
Please could you answer my previous question? Your answer is quite important for me! My question was:
Let's assume that company started own activity at the beginning 2011. Also company earned after-tax operating income 10 000$ during 2011. Reinvestment rate is equal to 40%. ROIC is equal to 15%. Consequently growth is equal to 0,15*0,40 = 6%.
My question is: FCFF in 2011 will be 10 000$ * (1-0,4) = 6 000$. I mean that company will be make an investments in the year in which after-tax operating income was obtained. Is it right?
I have another point of view. Maybe company should be make an investments at the beginning of 2012 (next year). In this case FCFF in 2011 will be 10 000$. And FCFF in 2012 will be 10 000$*1,06 - 4 000$ (reinvestments) = 6 600 $. Thus we see dropping of FCFF in 2012 comparing with 2011.
Dear Professor! Could you comment and thus help me. Which point of view is correct?
Growth should lag reinvestment by a year. To grow in 2012, the company will have to reinvest at the end of 2011.
ReplyDeleteThank you very much Dear Professor!!!
ReplyDeletehttp://tinyurl.com/bva8h9b
ReplyDeleteApple has 75b stacked outside of US with recorded tax liabilities running into a few billions it never intends to pay.
Dividend payments will be made out of cash in US only which means the cash that is outside does not have a planned use yet - no acquisitions; no reinvestment needs; no new products ....hmmmmm..is this a good sign ....is too much cash too bad?
I like your ideas. I started investing on emerging markets 6 years ago and it was one of my best decisions. Over that past few years i earned twice as much as im my investment in UK market.
ReplyDeleteDear Professor,
ReplyDeleteI would like to have your view on one important question while valuing the company.
Suppose, i am valuing a company which is handling ten different infrastructure projects.
In this case, how should i consider the risk premium and consequent cost of equity for each project individually in order to value each individual project using FCFE methodology.
Secondly, kindly express your view on risk premium for indivual project and the company?. Is it possible that individual project risk premium is less than company's overall equity risk premium?
Dear Professor!
ReplyDeleteI have spent a lot of time trying to solve one problem. You're my last hopefulness.
Is it right that value of company depends on tax rate?
Let's assume that we have two companies from USA and Japan. We know income, costs and tax rate for American company that are stated in USA Dollars. Given that we have current exchange rate Yen/USA and forecast of interest rates for Japan and USA we can calculate the future exchange rate Yen/USA. Also assume that we can obtain income and costs for Japanese company using these exchange rates. But value of company from USA will be different from value of company from Japan because tax rate in USA is not equal to tax rate in Japan.
I think that it's not enough and we have to do something else that value of company from USA will be the same as value of company from Japan.
Dear prof,
ReplyDeleteWe are in emerging country, so we have to add CRP. However, rf we use is government bond 10 years issued by our country, which already covers inflation and reputation risk,,,(about 10.5%). So if we add CRP, do we double the risks?
Thank you!
Dear....
ReplyDeleteMy opinion that we don't have to add CRP in this case. I would like to advise you to read Chapter №7 "Investment Valuation".
Thank you sir,
ReplyDeleteHowever, we are using equity risk premium of mature market, which is 6%. Is that appropriate? Cause we think we should have to add other risks for an emerging market
Thank You so much for the new paper on equity risk premiums.
ReplyDeleteGreetings Prof. Damodaran,
ReplyDeleteWhat you say about ERP in your article is from the viewpoint of an American Investor, am I right? The country risk premium for Iceland is 2%, based on the credit default spread. Should an Icelandic investor considering investment in an Icelandic company use it or omit it? Does it matter whether the company has only ISK income or a split between the ISK and foreign currencies?
Kind regards,
Johann V. Ivarsson
Iceland.
Dear Professor,
ReplyDeleteI am not able to access the current values of equity risk premium from your nyu link.
Is there an alternate link?
It seems as if the website is down both the nyu one and your personal one. Can you please email me the output for the latest country risk premium or let me know where I can find it.
ReplyDeleteCompanies in emerging markets often use creative accounting. I would always view their earnings as suspect. This is really true in countries like china where their have been chinese companies delisted from nasdaq because of their shady accounting.
ReplyDeleteAs we have seen earlier in this module, a stock is a part ownership interest in a company. You may get dividends – which are payable at the discretion of management – and you may get capital appreciation in the form of a rising share price; but whether the payment of dividends is an option for management is directly dependent on the company's performance (its profitability); and a rising share price depends on the market’s assessment of the company’s performance.
ReplyDeleteCommodity Tips
Dear Prof,
ReplyDeleteI am doing a real options valuation of different renewable electricity generation greenfield projects in Serbia (wind, photovoltaics, small hydro).
Can you tell me which country risk premium as well as which risk free rate should be used in the ROV calculation in this case (please explain if the values are continuous or annualized ones).
Do these inputs vary by different technologies (wind, solar, ...) and how, or not at all?
Also, what is the difference in the values of above mentioned inputs, if the investment is done by a global integrated oil&gas&power company and by a medium size regional power plant developer company. Thanks.
What a riot! AND, the Atlantis Sirki quilt your cat is enjoying Atlantis Sirki so much is gorgeously beautiful!
ReplyDeleteDear Prof,
ReplyDeleteHow would you fit CDS based country risk premiums with long term growth assumptions in terminal value? To make my point clear, you mentioned in one of your blogs that US LT interest rates fell since the credit crunch but the equity valuations have not responded in equal measure. This is because investors reduced their expectations of LT growth. Also, you mention interest rates (risk free) is in effect a reflection of LT nominal growth expectations and hence should be consistent in DCF assumptions.
In 2012, many emerging market CDSs and LT interest rates fell rapidly. While interest rates look consistent with lower CDSs (based on the country risk premium calculation framework you suggest), I am not so sure if they are consistent with the long term assumptions in DCF valuations. Say, turkish 10-year is below 7%, and most DCF valuations factor in 9-10% nominal growth in terminal value. My gut feeling is that we need to reduce long-term growth, but this seems to contradict with the view that cheap money will improve growth prospects. What would be the most consistent approach to tackle this new era of historic low interest rates, CDSs for emerging markets?
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ReplyDeleteThanks for the information
ReplyDeletecover your interest expenses/foregone interest income, the future earnings will comfortably. It is therefore entirely possible for an accretive deal to be value destroying and a dilutive deal to be value increasing. Matawan Tax Return preparer
ReplyDeleteThe equity premium puzzle is the lack of an explanation generally accepted by economists for the following situation: Much higher returns are achieved by stocks, but investments are still made in government bonds.latest technology
ReplyDeleteMy cousin recommended this blog and she was totally right keep up the fantastic work!
ReplyDeleteReconciliation Accounting
I completely agree with your article. It’s possible to know about it and it will snow me good ways of this topic. This is very nice post! I will bookmark this blog.
ReplyDeleteDear Professor,
ReplyDeleteI read your valuable article as well as a few others and I understand you would assume cost of equity to equal Rf + Beta x (ERP + CRP). However I would rather isolate CRP and add it to the Rf. Please assume a company in Peru only owns Govt bonds from Peru. In such a case you would expect a low beta (actually zero) meaning your expected return is now the US treasury yield which does not make sense. Hence I would disagree with the notion of scaling up the CDS. I would be glad to have your thoughts.
Best regards
Dear Professor,
ReplyDeleteThank you for the great research and analyses, and furthermore for sharing and distributing your analytics in such a user friendly format with the finance community.
I have a question regarding the spreadsheet, in the tab "Regional Weighted Average" column H,is a link to the tab "ERP by Country", which is Multiplication of default spread * volitily.
In the tab in the tab "Regional Weighted Average", two countries, however are hard-coded: Japan and Turkey. Is this intentional for those two countries or just a programming typo?
I need to calculate Japan total risk premium, and I am not sure if I could use the 7.05% that is in cell H34. Or as a spread to US, should I just use the .7%
Please advise. Thank you again for all your hard work.
Cheers,
Finance Student
Reza
Probably a basic question - Should not country risk be done through an alpha factor or an adjustment to Rf rather than ERP.
ReplyDeleteEffectively country risk should be the same irrespective of beta.
{I have seen the Big4 accounting firms do it this way}
Dear professor, I am wondering in data at Jan-14, there were large gap when computing ERPs using Moody's rating and CDS. These were cases of Venuzuela, vietnam, argentina. Why so and which one should be used?
ReplyDeleteDear Professor, should betas be calculated against the same index used to calculate the ERP? If I were to multiply a beta of a Brazilian company using the above spa index, to an ERP calculated using S&P 500, wouldn't it be wrong?
ReplyDeleteIt is estimated that that economic risks india is thought about eight times every day by socialists, many of whom fail to comprehend the full scope of economic risks india. In the light of this I will break down the issues in order to give each of them the thought that they fully deserve
ReplyDeleteTo use the risk premia for asset allocation decisions, wouldn't you have to have some measure of the probability that the equities of a particular country would deliver the premium? Or are you just suggesting comparing the risk premia to the inverse of the P/E multiples for each country to decide which are overvalued?
ReplyDelete