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The theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.

In theory, the risk-free rate is the minimum return an investor expects for any investment because he or she will not accept additional risk unless the potential rate of return is greater than the risk-free rate. In practice, however, the risk-free rate does not exist because even the safest investments carry a very small amount of risk. Thus, the interest rate on a three-month U.S. Treasury bill is often used as the risk-free rate.

April 18 2010| Filed Under Equity Valuation, Financial Theory, Portfolio Management, Risk Management In theory, stocks should provide a greater return than safe investments like Treasury bonds. The difference is called the equity risk premium: it is the excess return that you can expect from the overall market above a riskfree return. There is vigorous debate among experts about the method employed to calculate the equity premium and, of course, the resulting answer. In this article, we take a look at these methods - particularly the popular supply-side model - and the debates surrounding equity premium estimates.

Why Does It Matter? The equity premium helps to set portfolio return expectations and determine asset allocation policy. A higher premium, for instance, implies that you would invest a greater share of your portfolio into stocks. Also, the capital asset pricing relates a stock's expected return to the equity premium: a stock that is riskier than the market - as measured by its beta - should offer excess return above the equity premium.

Greater Expectations Compared to bonds, we expect extra return from stocks due to the following risks: 1. 2. Dividends can fluctuate, unlike predictable bond coupon payments. When it comes to corporate earnings, bond holders have a prior claim while common stock holders have a residual claim. 3. Stock returns tend to be more volatile (although this is less true the longer the holding period).

And history validates theory. If you are willing to consider holding periods of at least 10 or 15 years, U.S. stocks have outperformed treasuries over any such interval in the last 200 years.

But history is one thing, and what we really want to know is tomorrow's equity premium. Specifically, how much extra above a safe investment should we expect for the stock market going forward? Academic studies tend to arrive at lower equity risk premium estimations - in the neighborhood of 2-3%, or even lower! Later in this article, we'll explain why this is always the conclusion of an academic study, whereas money managers often point to recent history and arrive at higher estimations of premiums.

Getting at the Premium Here are the four ways to estimate the future equity risk premium:

What a range of outcomes! Opinion surveys naturally produce optimistic estimates, as do extrapolations of recent market returns. But extrapolation is a dangerous business: first, it depends on the time horizon selected, and second, we cannot know that history will repeat itself. Professor William Goetzmann of Yale has cautioned, "History, after all, is a series of accidents; the existence of the time series since 1926 might itself be an accident." For example, one widely accepted historical accident concerns the abnormally low long-term returns to bondholders that started right after World War II (and subsequently low bond returns increased the observed equity premium); bond returns were low in part because bond buyers in the 1940s and 1950s - misunderstanding government monetary policy - clearly did not anticipate inflation.

Building a Supply Side Model Let's review the most popular approach, which is to build a supply-side model. There are three steps: 1. Estimate the expected total return on stocks.

2. 3.

Estimate the expected risk-free return (bond). Find the difference: expected return on stocks minus risk-free return equals the equity risk premium.

We'll keep it simple and sidestep a few technical issues. Specifically, we are looking at expected returns that are long-term, real, compound and pre-tax. By long-term, we mean something like 10 years, as short horizons raise questions of market timing. (That is, it is understood that markets will be over or under-valued in the short run.)

By 'real', we mean net of inflation. Even if we estimated the stock and bond returns in nominal terms, inflation would fall out of the subtraction anyhow. And by 'compound', we mean to ignore the ancient question of whether forecasted returns ought to be calculated as arithmetic or geometric (time-weighed) averages.

Finally, although it is convenient to refer to pre-tax returns as do virtually all academic studies, individual investors should care about after-tax returns. Taxes make a difference. Let's say the risk-free rate is 3% and the expected equity premium is 4%; we therefore expect equity returns of 7%. Say we earn the risk-free rate entirely in bond coupons taxed at ordinary income tax rates of 35%, whereas equities may be deferred entirely into a capital gains rate of 15% (i.e., no dividends). The after-tax picture in this case makes equities look even better.

Step One: Estimate the Expected Total Return on Stocks Dividend-Based Approach The two leading supply-side approaches start with either dividends or earnings. The dividend-based approach says that returns are a function of dividends and their future growth. Consider an example with a single stock that today is priced at $100, pays a constant 3% dividend yield (dividend per share divided by stock price), but for which we also expect the dividend - in dollar terms - to grow at 5% per year.

In this example, you can see that if we grow the dividend at 5% per year and insist on a constant dividend yield, the stock price must go up 5% per year too. The key assumption is that the stock

price is fixed as multiple of the dividend. If you like to think in terms of P/E ratios, it is the equivalent to assuming that 5% earnings growth and a fixed P/E multiple must push the stock price up 5% per year. At the end of five years, our 3% dividend yield naturally gives us a 3% return ($19.14 if the dividends are reinvested). And the growth in dividends has pushed the stock price to $127.63, which gives us an additional 5% return. Together, we get a total return of 8%. That's the idea behind the dividend-based approach: the dividend yield (%) plus the expected growth in dividends (%) equals the expected total return (%). In formulaic terms, it is just a re-working of the Gordon Growth Model, which says that the fair price of a stock (P) is a function of the dividend per share (D), growth in the dividend (g) and the required or expected rate of return (k):

Earnings-Based Approach Another approach looks at the price-to-earnings (P/E) ratio and its reciprocal: the earnings yield (earnings per share stock price). The idea is that the market's expected long-run real return is equal to the current earnings yield. For example, at the end of 2003, the P/E for the S&P 500 was almost 25. This theory says that the expected return is equal to the earnings yield of 4% (1 25 = 4%). If that seems low, remember it's a real return. Add a rate of inflation to get a nominal return. Here is the math that gets you the earnings-based approach:

Whereas the dividend-based approach explicitly adds a growth factor, growth is implicit to the earnings model. It assumes the P/E multiple already impounds future growth. For example, if a company has a 4% earnings yield but doesn't pay dividends, then the model assumes the earnings are profitably reinvested at 4%. Even experts disagree here. Some "rev up" the earnings model on the idea that, at higher P/E multiples, companies can use high-priced equity to make progressively more profitable investments. Arnott and Bernstein - authors of perhaps the definitive study - prefer the dividend approach precisely for the opposite reason. They show that, as companies grow, the retained earnings they often opt to reinvest result in only sub-par returns - in other words, the retained earnings should have instead been distributed as dividends.

Handle with Care Let's remember that the equity premium refers to a long-term estimate for the entire market of publicly-traded stocks. Lately several studies have cautioned that we should expect a fairly conservative premium in the future.

There are two reasons why academic studies, regardless of when they are conducted, are certain to produce low equity risk premiums.

The first is that they make an assumption that the market is correctly valued. In both the dividend-based approach and earnings-based approach, the dividend yield and earnings yield have reciprocal valuation multiples:

Both models assume that the valuation multiples - the price-to-dividend and P/E ratio - are correct in the present and will not change going forward. This is understandable, for what else can these models do? It is notoriously difficult to predict an expansion or contraction of the market's valuation multiple. The earnings model might forecast 4% based on a P/E ratio of 25. And earnings may grow at 4%, but if the P/E multiple expands to, say, 30 in the next year, then the total market return will be 25%, where multiple expansion alone contributes 20%! (30/25 -1 = +20%)

The second reason low equity premiums tend to characterize academic estimates is that the total market growth is limited over the long-term. You'll recall that we have a factor for dividend growth in the dividend-based approach. Academic studies assume that dividend growth for the overall market - and, for that matter, earnings or

EPS growth - cannot exceed the total economy's growth over the long term. If the economy - as measured by gross domestic product (GDP) or national income - grows at 4%, then studies assume that markets cannot collectively outpace this growth rate. Therefore, if you start with an assumption that the market's current valuation is approximately correct and you set the economy's growth as a limit on long-term dividend growth (or earnings or earnings per share growth), a real equity premium of 4 or 5% is pretty much impossible to exceed.

Conclusion Now that we have explored the risk premium models and their challenges, it is time to look at them with actual data. The first step is to find a reasonable range of expected equity returns; step two is to deduct a risk-free rate of return and; and step three is to try to arrive at a reasonable equity risk premium.

A line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky marketa securities. Also refered to as the "characteristic line".

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta) axis represents the expected return. The market risk premium is determined from the slope of the SML.

The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable exp for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalu the investor would be accepting less return for the amount of risk assumed.

The risk inherent to the entire market or entire market segment. Also known as "un-diversifiable risk" or "market risk."

Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. Whereas this type of risk affects a broad range of securities, unsystematic risk affects a very specific group of securities or an individual security. Systematic risk can be mitigated only by being hedged.

A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas).

Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).

June 01 2013| Filed Under CAPM, Financial Theory, Harry Markowitz, Merton Miller, William Sharpe When it comes to putting a risk label on securities, investors often turn to the capital asset pricing model (CAPM) to make that risk judgment. The goal of CAPM is to determine a required rate of return to justify adding an asset to an already well-diversified portfolio, considering that asset's non-diversifiable risk.

The CAPM was introduced in 1964 by John Lintner, Jack Treynor, William Sharpe and Jan Mossin. The model is an extension of the earlier work of Harry Markowitz on diversification and modern portfolio theory. William Sharpe later received a Nobel Memorial Prize in Economics along with Merton Miller and Markowitz for their further contributions to CAPM-based theory.

As said above, the CAPM takes into account the non-diversifiable market risks or beta () in addition the expected return of a risk-free asset. While CAPM is accepted academically, there is empirical evidence suggesting that the model is not as profound as it may have first appeared to be. Read on to learn why there seems to be a few problems with the CAPM. Assumptions of Capital Market Theory, Markowitz-Style The following assumptions apply to the base theory: o o o o o All investors are risk averse by nature Investors have the same time period to evaluate information There is unlimited capital to borrow at the risk-free rate of return Investments can be divided into unlimited pieces and sizes There are no taxes, inflation or transactions costs

Due to these premises, investors choose mean-variant efficient portfolios, which by name seek to minimize risk and maximize return for any given level of risk.

The initial reaction to these assumptions was that they seem unrealistic; how could the outcome from this theory hold any weight using these assumptions? While the assumptions themselves can easily be the cause of failed results, implementing the model has proved difficult as well. The CAPM Takes a Few Hits In 1977, research conducted by Imbarine Bujang and Annuar Md Nassir poked holes in the CAPM model when they sorted stocks by earnings price characteristics. The findings were that stocks with higher earnings yields tended to have better returns than the CAPM would have predicted. More evidence mounted in the coming years (including Rolf W. Banz's work in 1981) uncovered what is now known as the size effect. Banz's study showed that small stocks as measured by market capitalization outperformed what CAPM would have expected.

While the research continues, the general underlying theme in all of the studies is that the financial ratios that analysts follow so closely actually contain some predictive information that is not completely captured in beta. After all, a stock's price is merely a discounted value of future cash flows in the form of earnings. With so many studies attacking the validity of CAPM, why in the world would it still be so widely recognized, studied and accepted? One explanation might be in the 2004 study conducted by Peter Chung, Herb Johnson and Michael Schill on Fama and French's 1995 CAPM findings. They found that stocks with low price/book

ratios are typically companies that have recently had some less-than-stellar results and may be temporarily out of favor and low in price. On the flip side, those companies with higher than market price/book ratios might be temporarily pumped up in price because they are in a growth stage.

Sorting firms on metrics like price/book or price/earnings ratios exposes investors' subjective reactions, which tend to be extremely good in good times and overly negative in bad times.

Investors also tend to over-forecast past performance, which leads to stock prices that are too high for high price/earnings firms (growth stocks) and too low for low P/E firms (value stocks). Once the cycle is complete, the results often mean higher returns for value stocks and lower returns for growth stocks.

Attempts to Replace CAPM Attempts have been made to produce a superior pricing model. Merton's (1973) intertemporal capital asset pricing model (ICAPM), for one, is an extension of the CAPM. The ICAPM varies from CAPM with a different assumption about investor objectives. In the CAPM, investors care only about the wealth their portfolios produce at the end of the current period. In the ICAPM, investors are concerned not only with their end-of-period payoff, but also with the opportunities they will have to consume or invest the payoff.

When choosing a portfolio at time (t1), ICAPM investors consider how an investor's wealth at t (time) could differ from future variables including labor income, the prices of consumption goods and the nature of portfolio opportunities at t. But while the ICAPM was a good attempt to solve the shortcomings of CAPM, it had its limitations as well.

Conclusion While CAPM still leads the pack as one of the most widely studied and accepted pricing models, it is not without its critics. Its assumptions have been criticized from the start as being too unrealistic for investors in the real world. Time and time again empirical studies successfully dissect the model.

Factors like size, various ratios and price momentum provide clear cases of diversion from the model's premise. This ignores too many other asset classes to be considered a viable option.

It is odd that so many studies are conducted to disprove CAPM as the standard market pricing theory, yet none to date seems to maintain the notoriety of the original one that was the theory behind a Nobel Prize.

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