Session 7: Estimating Hurdle Rates - Implied ERP, Country Risk and Company Risk

In this session seven of a 36 session corporate finance class, I'd like to continue our discussion of equity risk premiums. I'd like to offer you a forward looking dynamic way of estimating equity risk premiums that reflects what's going on around you, rather than looking backwards. In the last session, we talked about two ways of estimating equity risk premiums. You survey investors, which is largely a reactive way of estimating premiums, or you look backwards at historical risk premiums. In this session, I'd like to extend that discussion to come up with a dynamic forward looking way of estimating equity risk premiums. In terms of setting, we're still looking at estimating hurdle rates, and this is a part of that process of estimating hurdle rates. So here's how to think about forward looking dynamic premiums. Think about estimating the yield to maturity on a bond. You have the price of the bond, you've got the coupons and the face value. The yield to maturity in a bond is that internal rate of return, that discount rate, that makes the present value of your cash flows equal to the level of the price of the bond today. We're gonna extend that approach to come up with an implied equity risk premium for stocks. So as an example, let me go back to November 1st of 2013. The S&P 500 was at about 1754. The expected cash flows on stocks are not fixed, but I could tell you what the cash flows were in the previous year. And in the 12 months leading into November of 2013, those cash flows were about 82, that's in index units. Now there's a final piece of the puzzle. I have to estimate the expected cash flows of the future. To make that judgment, I went looking for an expected growth rate in cash flows. I couldn't find one in cash flows, but I did find one in growth and earnings for the S&P 500, it was about 5.59%. I think I have the pieces of the puzzle to put together. I know what you paid for stocks up front on November 1st of 2013. I have the cash flows in the most recent 12 months. I have an expected growth rate to apply to those cash flows. I use those numbers to come up with expected cash flows for the next five years. Why only five years? Remember, these are the 500 largest market cap stocks in the US. It's unlikely that they can keep growing at a rate faster than the growth rate of the economy. At the end of the fifth year, I'm going to put the growth rate of the cash flows to the growth rate of the economy. And to make that estimate, I'm going to use the risk-free rate as my proxy for the growth rate in the economy. That risk-free rate was 2.55%, so here's what we have. We have the cash flows for the next five years growing at 5.59% a year. Beyond year five, they grow at 2.55% a year in perpetuity. I solve for that discount rate that makes the present value of my cash flows equal to what you paid up front. When I solve for that number, I come up with a number, 8.04%. What does that tell me? On November 1st of 2013, if you bought US stocks, you could expect to make an 8.04% return over the long term on an annualized basis. Subtracting out the risk-free rate of 2.55%, I come up with an implied equity risk premium of 5.49%. It's a forward-looking, dynamic number. It will change on a day-to-day basis, and that is my other choice for equity risk premiums. So let's step back. The historical risk premium I computed in November of 2013, looking at the data through the end of 2012, was 4.20%. That's a geometric average premium for stocks over T bonds. The alternative premium I'm suggesting is 5.49%. That's a forward-looking, dynamic premium. I have to decide which premium to use in November of 2013. And my gut and my intuition tells me that the 5.5% I'm getting from the implied premium approach is a much more dependable, updated number. And that's what I'm going to use as my implied equity risk premium, or a risk premium for mature markets in November of 2013. You say, what about the remaining markets? I could try to compute an implied premium for India and China and Brazil. But it's difficult to do, at least with the information you have accessible right now. Getting expected growth rates for earnings and cash flows for the long term is tough to do in implied markets. So rather than compute an implied premium for each of these markets, I'm going to use a three-step approach to estimating country risk premiums. In the first step, I am going to get a mature market premium. The example that we've just talked about in November of 2013, that base number will be 5.5%, and I'm going to use that as my risk premium for the US. I'm then going to argue that any country with a AAA rating is a mature market. I know it's reaching, but it is simple. So all AAA-rated countries, that will include countries like Germany or Australia, will have the same equity risk premium as the US, 5.5%. If you are a riskier country, your rating is not AAA, then I'm going to add a spread to my equity risk premium for the US. We talked about estimating that spread in the last session. We start with the default spread for the country. We scale up that default spread to come up with a country risk premium for a country. Reminder again, when we did this for India, we started with a 2.4% default spread. We ended up with an equity risk premium of 3.6%. Actually, let me take that back. We started with a default spread of 2.25% and ended up with an equity risk premium of 3.6%. We ended up with an equity risk premium of an additional equity risk premium for Brazil of 3% and an additional equity risk premium for China, 1.44%. Those numbers are going to get added on to my 5.5% to come up with equity risk premiums, total equity risk premiums for each of those countries. In fact, to give you a complete picture of what the numbers look like in November of 2013, take a look at this picture. It has equity risk premiums by country for about 120 countries. I've computed the equity risk premiums using the approach I described in the last page. I've started with a 5.5%, and you'll notice that there are a lot of 5.5% on this table, and they go with countries with AAA ratings. For countries which do not have AAA ratings, I add that additional country risk premium to come up with a total equity risk premium by country, and you can see even within regions, there are big differences in risk premiums. So we now have a way of estimating equity risk premium by country. What I'd like to now talk about is estimating equity risk premiums for companies, and I'm going to start with Disney as my example. Disney's a US company, and you could take the lazy way out of saying it's a US company, so we're going to use the US equity risk premium. That's the way most people still estimate equity risk premium, but it strikes me as foolhardy, and here's why. Disney is a US company, but it has operations across the globe. In fact, you see the breakdown of Disney's revenues in 2013. 82% of its revenues come from the US, but 18% come from overseas. To estimate an equity risk premium for Disney, here's what I've done. I've taken the 82% in the US and given it the 5.5% equity risk premium I estimated for the US. For the rest of the world, I've estimated weighted average premiums for wherever Disney operates, and the composite average that I'm getting based upon revenue weights is 5.76%. Now you might wonder, why revenue weights? Part of it is informational. Most companies break down their geographical revenues, but they do not break them down by operating income or other measures. The second is practical. Revenues are always positive numbers, so your weights should also be positive, and that's a good thing. So my equity risk premium for Disney as a company is going to be 5.76%. In fact, using that approach, I get an equity risk premium for the remaining companies in my sample. For BookScape, which has one bookstore in New York, I use the US equity risk premium, and I'm done. For Baidu, which has its entire revenues pretty much from China, I use the equity risk premium for China, 6.94%, and I'm done. For Vale and Tata Motors, I've got to break the revenues down by country or by region to come up with an equity risk premium for these companies. Notice that Tata Motors gets almost as much revenues from China as it does from India. That's a residue of its Land Rover acquisition. For Deutsche Bank, I have to break revenues down by region and come up with an equity risk premium by country and a weighted average for the company. In effect, I'm doing what I did for Disney for each of these companies. Now let me go back to my implied equity risk premium. I told you it was a forward-looking dynamic number. You're saying, how dynamic? Let me take a period in history where you can see how dynamic implied premiums were. This is the last quarter of 2008, starting September 12th of 2008. That is the Friday before the Lehman collapse through November 31st. The equity risk premium at the start of this period was 4.37%. That's a pre-crisis premium. I computed the implied equity risk premium every day through the crisis. And you can see there was a day in November of 2013. This is two and a half months later, where the implied premium in the US hit 8%. It almost doubled. That's why we compute dynamic forward-looking premiums, because the world can shift around you. And as it shifts, your equity risk premium should shift as well. Now let me update this number, because to show you how much it changes, I'm going to go to January 2014, two months after my original estimate from November of 2013. I updated my numbers. The S&P 500 has now climbed to 1,858. My cash flows are a little higher, around 84. My expected growth rate a little lower at 4.28%. My risk-free rate has changed a little bit to 3.04%. But again, I go through the process of estimating an internal rate of return, that discount rate that makes the present value of my cash flows equal to the level of the index. At the start of 2014, that number is 8%. You subtract out the risk-free rate, the implied equity risk premium on January 1st of 2014 is about 5%. It's really 4.96%, much below what we estimated just two months prior. Now to give you a sense of history, I went back and computed the implied equity risk premiums, starting in 1960, going all the way through the end of 2013. You look at this graph, you get a sense of US stock market history for the last 50 to 60 years. You look at the 1960s, a remarkably stable period for implied equity risk premiums, between 3% and 3.5%. When you get to the 1970s, notice how they spike. That's not a good thing if you're a stockholder, because stock prices are collapsing. That, of course, was the residue of the high inflation of the 1970s. Inflation is deadly for stocks. 1978, equity risk premiums peak at about 6.5%. The Dow is at about 900. Then for the next 20 years, you see one of the great bull markets of all time. In fact, by the end of 1999, the implied equity risk premium in the US had hit 2%. That was the peak of the dot-com boom. Think about it. I'm offering you 2% more than the risk-free rate to invest in stocks, and people were still investing, because there was a correction right after. Then you got about five years where the equity risk premium stayed around 4%. You have the 2008 crisis, where you see the spike. And since that spike, what you notice is how volatile equity risk premiums have become. The lesson I take out of this is never again will I look back at historical risk premiums. They tend to be static, and we live in a world where equity risk premiums are now both more dynamic and more volatile. So that is the basis for computing implied premiums. And to update the numbers, these are the global estimates of equity risk premiums in January 2014. Incidentally, this is an update that I do at the start of every year. And in fact, it's a number that I draw on for the rest of the year when I value companies during the course of the year. So here's the bottom line. If you're interested in estimating an equity risk premium for your company, start off by looking at where it operates, not where it's incorporated. Then try to get the equity risk premiums for each part of the world that it operates in. If it's individual countries, get the equity risk premium by country. If it's regions, you can take the weighted average by region, and you will end up with an equity risk premium for your company. It's an essential second piece now that you have a risk free rate in moving towards a hurdle rate for your company. Thank you very much for listening.