RETURN CONCEPTS

27 March 2025
WHY FOCUS ON RETURN CONCEPTS?

To estimate discount
rates for valuation
 RETURN
Financial assets normally generate two types of return for
investors:

• Periodic income e.g interest, dividend

• Capital gain/ loss from price increase or decrease

Some instruments provide return through one of these

mechanisms e.g non-dividend paying stocks provide
capital gain/loss; pension plans and retirement annuities
provide income payments as long as you live.
 HOLDING PERIOD RETURN
( 𝑃 1 − 𝑃𝑜 ) + 𝐼
𝐻𝑃𝑅 =
𝑃0

Where:
P1 = price at the end of the period
P0 = price at the beginning of the period
I = income
(P1 – P0) = capital gain component
 HOLDING PERIOD RETURN

DH  PH
r 1
P0
DH PH  P0
r 
P0 P0

Where:
DH = dividend
P0 = price at the beginning of the period
PH = price at the end of the period
 REALIZED HPR VS EXPECTED HPR VS
REQUIRED HPR
• If the holding period return is one that the investor earned
in the past, we refer to it as a realized return.

• If the holding period return is one that the investor expects

to earn in the future, we refer to it as an expected return.

• A required rate of return (for short, required return) is

the minimum level of expected return that an investor
requires in order to invest in the asset over a specified time
period, given the asset’s riskiness.
 CALCULATING REQUIRED RETURN

Current
Required Equity
expected
return on risk
risk-free
equity premium
return
 EQUITY RISK PREMIUM ESTIMATES

There are two approaches to estimating

equity risk premium:

1. Historical Estimates
2. Forward-Looking Estimates
- Gordon growth model estimates
- Macroeconomic model estimates
- Survey estimates
 HISTORICAL ESTIMATES

Using historical data:

Equity risk premium = Return on a broad-based

equity market index – Return on government debt.
 ISSUES IN USING HISTORICAL EQUITY
RISK PREMIUM ESTIMATES
• Length of Sample Period
- Balancing long-term and short-term considerations
• Geometric vs. Arithmetic Mean
- Geometric mean reflects future value more accurately
• Choice of Risk-Free Return
- On-the-run long-term Treasuries
• Survivorship Bias
- Using returns from surviving firms artificially inflates estimates of
return
• Strings of Unusual Events
 FORWARD-LOOKING EQUITY
RISK PREMIUM ESTIMATES: GORDON
GROWTH MODEL

Equity risk Dividend Earnings Government

premium yield growth rate bond yield
 FORWARD-LOOKING EQUITY
RISK PREMIUM ESTIMATES: MACROECONOMIC
MODEL

ERP (1  EINFL)(1  EGREPS)(1  EGPE)  1  EINC  RF

where
EINFL = Expected inflation
EGREPS = Expected growth rate in real earnings per share
EGPE = Expected growth in the P/E
EINC = Expected income component
RF = Expected risk-free return
 EXAMPLE:
FORWARD-LOOKING EQUITY RISK PREMIUM

Expected inflation 2%
Expected growth in real earnings per share 2.5%
Expected growth in the P/E 0.0%
Expected dividend yield 2.7%
Return from reinvestment of income 0.1%
Expected Income 2.8%
Risk free rate 3.8%
 EXAMPLE:
FORWARD-LOOKING EQUITY RISK PREMIUM

Macroeconomic model equity risk premium

= ERP (1  EINFL)(1  EGREPS)(1  EGPE)  1  EINC  RF
(1  0.02)(1  0.025)(1  0)  1.0  0.028  0.038
3.5%
 FORWARD-LOOKING EQUITY
RISK PREMIUM ESTIMATES: SURVEYS

This involves asking experts about their capital

market expectations
 ESTIMATING THE REQUIRED RETURN ON
EQUITY

The required return on equity can be calculated

using the following models:
• Capital Asset Pricing Model
• Multi factor models
• Build-up methods
 CAPITAL ASSET PRICING MODEL
(CAPM)

𝐸 ( 𝑅𝑖 )= 𝑅 𝐹 + β 𝑖 ( 𝐸𝑅𝑃 )

Where:
E(Ri) = Required return on equity for security i
RF = Current expected risk-free return
i = Beta of security i
ERP = Equity risk premium
 BETA ESTIMATION

Choice of • S&P 500 Index and NYSE

Market Composite are common
Index choices in the United States

Length & • Five years of monthly data

Frequency is most common choice
of Data
 MULTIFACTOR MODELS:
FAMA–FRENCH MODEL

Market
Size
Risk
Premium
Premium

Risk-
Value
Free Required Premium
Return Return
on
Equity
MULTIFACTOR MODELS: FAMA–FRENCH MODEL
ri RF  β imkt RMRF  β isizeSMB  β ivalue HML,
• where
- SMB = The return to small stocks minus the return to large stocks
- βsize = The sensitivity of security i to movements in small stocks
- HML = The return to value stocks minus the return to growth stocks
- βvalue = The sensitivity of security i to movements in value stocks

MULTIFACTOR MODELS: PASTOR–STAMBAUGH

mkt MODEL
size value liq
ri RF  βi RMRF  β i SMB  β i HML  β i LIQ,

• where
- LIQ = The return to illiquid stocks minus the return to liquid stocks
- βliq = The sensitivity of security i to movements in illiquid stocks
 EXAMPLE:
FAMA–FRENCH MODEL

Risk-free rate 3.0%

Equity risk premium 5.0%
Beta 1.20
Size premium 2.2%
Size beta 0.12
Value premium 3.8%
Value beta 0.34
 EXAMPLE:
FAMA–FRENCH MODEL

mkt size value

ri RF  β RMRF  β SMB  β
i i i HML
3%  1.20(5%)  0.12(2.2%)  0.34(3.8%)
10.56%
 BUILD-UP METHODS

A traditional specific implementation is as follows:

INTERNATIONAL CONSIDERATIONS FOR
REQUIRED RETURNS

Exchange Rates

Emerging Markets
• Country spread model
• Country risk rating
model
 WEIGHTED AVERAGE COST OF CAPITAL
(WACC)

Weighted
Average
Cost of Capital

Debt Equity

Market Market
Cost of Cost of
Value of Tax Rate Value of
Debt Equity
Debt Equity
 WEIGHTED AVERAGE COST OF CAPITAL

MVD MVCE
rd (1  Tax rate)  re
MVD  MVCE MVD  MVCE
• Where
- MVD = Current market value of debt
- MVCE = Current market value of common equity
- rd = Before-tax cost of debt (which is transformed into the after-tax cost by
multiplying it by 1 – Tax rate)
- re = Cost of equity
 EXAMPLE:
WEIGHTED AVERAGE COST OF CAPITAL

Risk-free rate 3.0%

Equity risk premium 5.0%
Beta 1.20
YTM of long-term bond 6.1%
Long-term debt/Total capital at market value 40%
Tax rate 30%
 EXAMPLE: WEIGHTED AVERAGE COST OF
CAPITAL

𝑟 𝑒 =𝑅 𝐹 + β𝑖 [ 𝐸𝑅𝑃]
MVD MVCE
WACC  rd (1  Tax rate)  re
MVD  MVCE MVD  MVCE

0.40(6.1%)(1  0.30)  0.60(9.0%)

7.11%
 CHOICE OF DISCOUNT RATE

Cash Flow • WACC

to the Firm
Cash Flow • Required return on equity
to Equity
Nominal • Nominal discount rates
Cash Flows
Real Cash • Real discount rates
Flows
 OTHER RETURN CONCEPTS

Return from
Convergence Internal Rate
Required Discount
of Price to of Return
Return Rate
Intrinsic (IRR)
Value
 SUMMARY

Return Concepts

• Holding period return, realized return, expected return,

required return, discount rate, return from convergence of
price to intrinsic value, and IRR

Equity Risk Premium

• = Required return on equity – Risk-free return

• Historical estimates
• Issues in estimation: Sample period length, geometric versus
arithmetic mean, risk-free return choice, survivorship bias,
strings of unusual events
• Forward-looking estimates: Gordon growth model estimates,
macroeconomic model estimates, survey estimates
 SUMMARY
Models for the Required Return on Equity
• Capital asset pricing model (CAPM)
• Multifactor models
• Fama–French model
• Pastor–Stambaugh model
• Macroeconomic models
• Statistical models
• Build-up method

Beta Estimation Issues

• Choice of market index
• Length and frequency of data
• Adjusted betas
• Thinly traded and private firms
 SUMMARY
International Considerations for Required
Returns
• Exchange rates
• Emerging markets

Weighted Average Cost of Capital

• Use market values, marginal tax rates, current bond YTM,

and equity required return

Choice of Discount Rate

• Use WACC for firm cash flows

• Use equity required return for equity cash flows
• Use nominal rates for nominal cash flows
 OTHER RETURN CONCEPTS

Return from
Convergence Internal Rate
Required Discount
of Price to of Return
Return Rate
Intrinsic (IRR)
Value