VALUATION METHODS

LESSON 3: RETURN CONCEPTS AND THE EQUITY RISK PREMIUM

LO 1: Distinguish among realized holding period return, expected holding period return,
required return, return from convergence of price to intrinsic value, discount rate, and
internal rate of return

Holding Period Return

The holding period return (HPR) is the return earned on an investment over the entire investment
horizon (whatever it may be). The return on an equity investment comes from investment income
(dividends) and price appreciation (capital gains). Therefore, the holding period return can be broken
down into the dividend yield (DH / P0 ) and the price appreciation return [(PH – P0) / P0 ].

Holding period return = PH – P0 + DH

P0

PH = Price at the end of the holding period

P0 = Price at the beginning of the period
DH = Dividend

• In the equation above, we have assumed that the dividend is received at the end of the holding
period (t = H). if this is not the case, the HPR is calculated based on reinvestment of interim
cash flows in additional shares at the current market price.
• Annualizing the HPR (especially the return over a short time horizon) may be unrealistic as
the HPR may not accurately reflect the reinvestment rate available over an entire year.
• An HPR that is computed based on past information (historical market prices and dividend
payments) is referred to as a realized holding period return.
• An estimate of HPR in a forward-looking context (where future market prices and dividend
payments are not known) is referred to as an expected holding period return.

Required Return

The required return represents the minimum rate of return required by an investor to invest in an
asset over a specified period of time given its level of risk. Stated differently, it represents the
opportunity cost of investing in the asset (i.e., the highest level of expected return available from
another asset of similar risk).

• The difference between an asset’s expected return and required return is known as expected
alpha, ex ante alpha, or expected abnormal return
 o Expected alpha = Expected return – Required return
• The difference between the actual (realized) return on an asset and its required return is
known as realized alpha or ex post alpha.
o Realized alpha = Actual HPR – Required return for the period

If an asset’s current price equals its perceived intrinsic value, the expected return should be the same
as the required return, in which case expected alpha equals zero. However, if an asset’s current price
is lower (greater) than its perceived value, the expected return should be greater (lower) than the
required return, and expected alpha should be positive (negative), as long as the market price
converges to intrinsic value over the investor’s time horizon.

Therefore, when the investor’s estimate of intrinsic value (V0) is different from the current market
price (P0), the investor’s expected return has two components:

1. The required return (rT) earned on the asset’s current market price; and
2. The return from convergence of price to value [(V0 – P0) / P0].

Illustrative Problem. At the end of 2024, Appol’s stock was trading at P46 per share, while
analysts estimated its intrinsic value to be P52. The required return on equity for Appol was
estimated to be 8.5% per annum.

Required:
1. Estimate the expected 6-month holding period return on the stock if the market price is
expected to converge to intrinsic value in 6 months.
2. Estimate the expected one-year return on the stock if the market price is expected to
converge to intrinsic value in 2 years.

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Note that there are risks involved in “second guessing” the market price.
• The investor’s estimate of intrinsic value may not necessarily reflect the asset’s true intrinsic
value.
• Even if the investor is able to estimate the asset’s intrinsic value more accurately than the
market, convergence of price to value may not occur within the investor’s time horizon.

Discount Rate

The discount rate represents the rate used by investors to calculate the present value of a future cash
flow. It is usually calculated as the risk-free rate plus a spread that reflects the risk associated with the
cash flow. The discount rate is therefore based on the characteristics of the investment. However,
considering the limitations of finance models, it may be (subjectively) adjusted by investors to reflect
their expectations.

Internal Rate of Return

The internal rate of return (IRR) of an investment is the discount rate that equates the present value
of expected cash flows from the asset to its price. Based on the stable dividend growth, the intrinsic
value of a stock can be estimated as:

Intrinsic value = Next year’s expected dividend .

Required return – Expected dividend growth rate

V0 = D1__
ke – g

If the asset is assumed to be efficiently-priced (i.e., the market price equals its intrinsic value), the IRR
would equal the required return on equity. Therefore, the IRR can be estimated as:

𝑁𝑒𝑥𝑡 𝑦𝑒𝑎𝑟 ′ 𝑠 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑

Required return (IRR) = + 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒

𝐷1
𝑘𝑒 (𝐼𝑅𝑅) = +𝑔
𝑃0

Note that when we use the IRR as an estimate of required return, we assume that the market is efficient
and that the present value model is correct. For example, in applying the constant-growth dividend
discount model above we are assuming that our expected dividend growth rate is correct.

LO2: Calculate and interpret an equity risk premium using historical and forward-looking
estimation approaches.

EQUITY RISK PREMIUM

The equity risk premium (ERP) refers to the additional return (premium) required by investors to
invest in equities rather than a risk-free asset. Stated differently, it equals the difference between the
return on a broad equity market index and the risk-free rate of return.

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 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 + 𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚

The required rate of return on a particular stock can be computed using either of the following two
approaches. Both these approaches require the equity risk premium to be estimated first.

1. Required return on share i = Current expected risk-free return + βi Equity risk premium.
• A beta greater (lower) than 1 indicates that the security has greater-than-average (lower-
than-average) systematic risk.

2. Required return on share i = Current expected risk-free return + Equity risk premium ± Other
risk premia/discounts appropriate for i.
• This method of estimating the required return is known as the build-up method. It is
primarily used for valuations of private businesses.

The equity risk premium may be estimated based on historical data or forward-looking estimates.

Historical Estimates

A historical equity risk premium is calculated as the mean value of the difference between returns on
a broad-based equity market index and the return on government debt over a specific time period.

Advantages:
• This method is relatively simple and resulting estimates are objective.
• If it is assumed that investors do not make systematic errors in forming expectations, historical
estimates of average returns are unbiased.

However, this method is based on the assumption that the mean and variance of returns are stationary
(i.e., constant over time), which is not always the case. Therefore, analysts must be very careful in
choosing the sample period over which they calculate the equity risk premium. While using a longer
sample period theoretically increases precision in estimating the mean, there may be sub-periods
during which the assumption of stationarity does not hold for the series.

Aside from the sample period, major decisions involved in developing a historical equity risk premium
estimate include:
• Selection of the equity market index to represent equity market returns.
o Typically, broad-based market value weighted indices are selected.
• Selection of the type of mean equity risk premium calculated. The mean value of the difference
between equity market index returns and government debt returns can either be calculated
using the arithmetic mean or geometric mean.
o Analysts are increasingly leaning toward the geometric mean in estimating the
historical equity risk premium.
• Selection of the proxy for the risk-free rate of return (short-term versus long-term government
bond yield).
o There is a general preference for using the long-term government bond yield as the
risk-free rate.

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Adjusted Historical Estimates

An estimate of the historical equity risk premium may need to be adjusted (1) for the effect if biases in
the data series, or (2) to tweak the estimate to make it more representative in a forward-looking
context.

• Poorly-performing companies are usually removed from equity market indices over time,
while those that consistently perform strongly remain. Therefore, survivorship bias tends to
inflate historical estimates of the equity risk premium. Analysts should make a downward
adjustment to the estimate derived from a series with such a bias.
• Other adjustments may be related to a string of positive or negative events and surprises that
do not balance out over the sample period. A string of positive (negative) surprises may result
in a series of relatively high (low) returns. In order to make the historical equity risk premium
estimate reflective of more “normal” market conditions, it will be revised downwards
(upwards).

Forward-Looking Estimates

Forward-looking estimates of the equity risk premium are based on current information and future
expectations of relevant variables. In contrast to historical estimates, forward-looking estimates are
free from data biases and issues such as nonstationarity. However, they are exposed to (1) modelling
errors and (2) potential behavioral biases in forecasting.

Gordon Growth Model (GGM) Estimates

The Gordon growth model is fairly easy to apply in developed economies where broad-based equity
indices are closely associated with a dividend yield, and year-ahead dividend payments are usually
fairly predictable. The model calculates the required return on equity assuming a constant long-term
growth rate in earnings and dividends. Based on this model, the equity risk premium is calculated as
the difference between the required return on equity (calculated as the expected dividend yield plus
the growth rate in dividends) minus the long-term government bond yield (rLTGD):

𝐷1
𝐺𝐶𝑀 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒 = + 𝑔 − 𝑟𝐿𝑇𝐺𝐷
𝑃0

A problem with this model is that (just like historical estimates) Gordon growth model estimates also
change over time. Generally speaking, during a boom (recession) dividend yields are low (high),
growth expectations are high (low) and government bond yields are high (low).

The GGM assumption of a constant growth rate in earnings and dividends may not be appropriate for
economies that grow very rapidly. For such economies, an assumption of multiple earnings growth
stages is applied, where stages of growth are usually classified as rapid growth, transition growth, and
mature (sustainable) growth. The cash flows during each of the growth phases are estimated and then
the uniform discount rate of IRR (r) is computed that equates the present value of those cash flows to
the current market price of the equity index.

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Equity index price = PV Fast growth stage CF discounted at r
+ PV Transition stage CF discounted at r
+ PV Mature stage CF discounted at r

The long-term government bond yield is then subtracted from the estimated of IRR (r) obtained from
the exercise described above to obtain a forward-looking estimate of the equity risk premium for
rapidly growing economies.

Macroeconomic Model Estimates

Macroeconomic models (also known as supply-side models) use relationships between

macroeconomic variables and financial variables used in equity valuation models to estimate the
equity risk premium. The use of macroeconomic models is more appropriate in developed countries
where public entities represent a relatively large share of the economy. These models usually focus on
supply-side variables that fuel growth in gross domestic product. Based on Ibbotson and Chen’s (2003)
model for the return on equity, the equity risk premium can be estimated as:

Equity risk premium = {[(1 + EINFL) (1 + EGREPS) (1 + EGPE) – 1] + EINC} – Expected RF

• Expected inflation (EINFL) can be calculated as the difference between the yields for long-
term Treasury bonds and Treasury Inflation Protected Securities (TIPS) of a similar maturity.

1 + 𝑌𝑇𝑀 𝑜𝑓 20 𝑦𝑒𝑎𝑟 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑇𝐵𝑜𝑛𝑑𝑠

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = −1
1 + 𝑌𝑇𝑀 𝑜𝑓 20 𝑦𝑒𝑎𝑟 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑇𝐼𝑃𝑆

• The expected growth rate in real earning per share (EGREPS) can be estimated as the sum of
labor productivity growth and labor supply growth.
• The expected growth rate in the P/E ratio (EGPE) has a baseline value of zero. However, it
may be positive (negative) if the analyst views the market as currently undervalued
(overvalued).
• The expected income component (EINC) can be based on historical rate (e.g., 5.75% in the
Philippines as of February 2025) and tweaked according to forward-looking estimates.

Survey Estimates

These involve asking a sample of people (usually experts) about their expectations regarding the equity
risk premium, or about their capital markets expectations (from which the expected equity risk
premium can be inferred) going forward.