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Valuation_Session6

The document discusses various methods for estimating the cost of equity, focusing on the risk-free rate, equity risk premium, and beta estimation. It highlights the challenges of using historical beta due to market conditions and suggests alternative approaches like the bottom-up beta method. Additionally, it examines the impact of financial leverage on beta and the limitations of accounting betas in accurately reflecting risk.

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keshavnotanib29
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10 views10 pages

Valuation_Session6

The document discusses various methods for estimating the cost of equity, focusing on the risk-free rate, equity risk premium, and beta estimation. It highlights the challenges of using historical beta due to market conditions and suggests alternative approaches like the bottom-up beta method. Additionally, it examines the impact of financial leverage on beta and the limitations of accounting betas in accurately reflecting risk.

Uploaded by

keshavnotanib29
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Estimating the Cost of Equity

Prof. Abhinav Sharma


Assistant Professor (Finance)
Goa Institute of Management
India

January 7, 2025
Cost of Equity and Risk Free Asset

Expected Return = Risk Free Rate + β (Risk Premium)

What classifies as a risk-free asset?

Default risk vs Reinvestment risk.

Assuming you want to invest in a risk-free asset for 5 years. Is


T-bills a good option?
Other Components of Cost of Equity

Equity Risk Premium can be estimated through historical


data.

But, are the historically estimated numbers reliable?

Another alternative is to estimate the implied equity


premium.

Expected Dividends next period


Value = Required Return on Equity −Expected Growth Rate
Estimating Betas

Ri = a + b R m

The slope of the regression corresponds to the Beta of the


stock.

Betas using historical data are also provided by platforms


such as Bloomberg, Value Line, Morning Star, etc.

Three critical factors, length of the estimation period, return


interval, and choice of market index.
Issues with Historical Beta Estimation
When liquidity is limited in case of smaller and emerging
markets, Beta intervals using small intervals may be
biased.

Indices in smaller markets are dominated by a few large


companies; Eg, DAX dominated by Allianz, Deutsche
Bank, etc.

For private firms or firms who have just gone public,


market price history may not be available.

If the firm has undergone significant restructuring,


divestiture, or recapitalization, regression betas become
meaningless.

The biggest problem with regression beta is its Standard


Error.
Alternate method of Estimating Betas
One can calculate Beta using the fundamentals of the
business, including the type of business, operating leverage
and financial leverage employed by the firm.

Increasing the financial leverage will increase the beta of the


equity in a firm.

βL = βU [1 + (1 − t)(D/E )

The levered Beta will depend on the riskiness of the business


and the amount of financial leverage risk.

The unlevered Beta of a firm is determined by the nature of


its product and services (cyclicity, elasticity, etc.) and
operating leverage.
Why Bottom-Up Beta Approach?
The Beta of two assets put together is a weighted average of
the individual asset betas, with the weights based on market
value.

Although each regression beta has standard error, the average


of betas has much lower standard errors.

If a firm restructured its operations by divesting a major


portion of its business recently, the weights can be adjusted
accordingly.

Bottom-up Beta uses current D/E ratios, therefore any


changes in the firm’s D/E can be factored in accordingly.

Can be employed for private firms, newly traded firms,


divisions of business, etc.
Accounting Betas
Change in earnings, on a quarterly or annual basis, can be
related to changes in earnings for the market, in the same
periods.

However, accounting earnings are usually smoothed out, as


managers spread earnings and expenses across periods.

This may lead to ”biased down” betas for risky firms and
”biased up” betas for safer firms.

Non-operating factors such as change in depreciation


inventory methods may influence betas.

Accounting data will be available only at quarterly and yearly


frequency, resulting in regression with too few observations.
Which Beta Estimation Approach is better?
References

References I

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