PES Business Review

Open Access Open Access  Restricted Access Subscription Access

Equity Valuation: Premium to Interest Rate Structure Model


Affiliations
1 Business Schools, Bangalore, India
 

Among the Equity Valuation models, the Discounting of cash flow (DCF) uses the cost of equity capital as a discounting rate in determining the value of equity. The cost of equity capital is usually calculated using the CAPM. The capital asset pricing model is backward looking as its components like beta and risk premium are based on the historical data. Most factor models used in academics and in practice consider historical data of stock returns and index to determine the cost of equity. The stock price which reflects the present value of future cash flows cannot be completely based on historical data for discounting. This paper proposes a modified model of DCF which takes into account a forward looking cost of equity capital. The model will include the time dynamic changes in the components of the cost of capital as opposed to those with time static components. It is proposed to use the forward looking risk free rate, obtained through bootstrapped spot curve, to which the forward looking time dynamic risk premium times the forward looking beta is added in order to arrive at the cost of equity. This forward looking cost of equity is then used for discounting of the estimated future cash flows to arrive at the value of the stock.

Keywords

Equity Valuation, Forward Looking Beta, Forward Looking Risk Premium.
User
Notifications
Font Size

  • Bakshi, G. and D. Madan. (2000). Spanning and Derivative Security Valuation, Journal of Financial Economics, Vol. 55, pp. 205-238.

  • Bakshi, G., N. Kapadia and D. Madan. (2003). Stock Return Characteristics, Skew Laws, and Differential Pricing of Individual Equity Options, Review of Financial Studies, Vol. 10, pp. 101-143.

  • Black, F., M. Jensen, and M. Scholes, (1972). The Capital Asset Pricing Model: Some Empirical Tests, in M. Jensen (editor): Studies in the Theory of Capital Markets, Praeger, New York, NY.

  • Blume, M. (1975). Betas and Their Regression Tendencies, Journal of Finance, Vol. 30, pp.785-795.

  • Britten-Jones, M. and A. Neuberger (2000). Option Prices, Implied Price Processes, and Stochastic Volatility, Journal of Finance, Vol 55, pp. 839-866.

  • Chen, Ren-Raw, Doncheol Kim, and Durga Panda (2009). On the Ex-Ante Cross-Sectional Relation Between Risk and Return Using Option-Implied Information, working paper.

  • Choudhry, T (2002). The Stochastic Structure of the Time Varying Beta: Evidence from UK Companies, The Manchester School, Vol 70(6), pp. 768-791.

  • Choudhry, T. (2004). Time-varying beta and the Asian financial crisis: Evidence from Malaysian and Taiwanese firms, Pacific-Basin Finance Journal, Vol 13(1), pp. 93-118.

  • Damodaran A. (2002). Investment Valuation - Tools and Techniques for determining the value of any asset, John Wiley & Sons, 2nd edition, pp. 182.

  • Damodaran. A. (2008). What is the riskfree rate? A Search for the Basic Building Block, www.stern.nyu.edu

  • Dennis, P. and Mayhew, S. (2002). Risk-Neutral Skewness: Evidence from Stock Options, Journal of Financial and Quantitative Analysis, Vol. 37, pp. 471-493.

  • Basu. D and Stremme. A, (2007). CAPM and Time-varying Beta: The Cross Section of Expected Returns, Working paper, www.ssrn.com/abstract=972255

  • Duan, J.-C. and J. Wei. (2005). Is Systematic Risk Priced in Options? Working Paper, University of Toronto, Canada.

  • Elton, Edwin J., Martin J. Gruber, Sanjiv Das and Matt Hlavka (1993). Efficiency with Costly Information: A Reinterpretation of Evidence from Managed Portfolios, Review of Financial Studies, Vol. 6(1), pp. 1-22.

  • Ehrhardt. M C and Brigham E. F. (2009). Corporate Finance A Focused approach, Southwestern Cenage Learning, 3rd edition, chapter 5, pp. 168

  • Fama, E. and French K. (1992). The CrossSection of Expected Stock Returns, Journal of Finance, Vol. 47, pp. 427-465.

  • Fama, E., & French, K. (1997). Industry costs of equity, Journal of Financial Economics, Vol 43, pp. 153-193.

  • Fama, E. and French, K. (2004). The CAPM: Theory and Evidence, Journal of Economic Perspectives, Vol 18, pp. 25-46.

  • Faff, R. W., Hilier, D., and Hilier, J. (2000). Time Varying Beta Risk: An Analysis of Alternative Modelling Techniques. Journal of Business Finance & Accounting, Vol 27.

  • Ferson, W. E. (1989). Changes in expected security returns, risk and the level of interest rates. Journal of Finance, Vol 44, pp. 1191-1214.

  • Ferson,W. E., Harvey, C. R. (1993). The risk and predictability of international equity returns, Review of Financial Studies, Vol 6, pp. 107-131.

  • Ferson,W.E. and Korajczyk,R.A. (1995). Do arbitrage pricing models explain the predictability of stock returns?, Journal of Business, Vol 68, pp. 309-349.

  • Friend, Irwin and Marshall Blume (1970), Measurement of Portfolio Performance under Uncertainty, American Economic Review. Vol 60(4), pp. 607-636.

  • Gangadhar Darbha, Sudipta Dutta Roy and Vardhana Pawaskar, (2003). Term Structure of Interest Rates in India: Issues in Estimation and Pricing, Indian Economic Review New Series, Vol. 38(1), pp. 1-19.

  • Husmann, Sven, and Andreas Stephan (2007), On Estimating an Asset's Implicit Beta, Journal of Futures Markets, Vol 27, pp. 961-979.

  • Jiang, G. and Y. Tian (2005). The Model-Free Implied Volatility and Its Information Content, Review of Financial Studies, Vol 18, pp. 1305-1342.

  • Jin-Chuan Duan and Weiqi Zhang (2013). Forward-Looking Market Risk Premium, Management Science, pp. 521-538

  • Merton, Robert C. (1980). On Estimating the Expected Return on the Market: An Exploratory Investigation, Journal of Financial Economics, Vol. 8, pp.323-361.

  • Monaghan A. (2014). The AAA-rated club: which countries still make the grade?, The Guardian, www.theguardian.com/business/ economics-blog/2014/oct/15/the-aaa-ratedclubwhich-countries-still-make-the-grade

  • Mukherji. S. (2011). The Capital Asset Pricing Model's Risk free rate, The International Journal of Business and Finance Research, Vol 5(2), pp 75-83.

  • Mullins, D W. Jr, (1982). Does the Capital Asset Pricing Model Work?, Harvard Business Review.

  • Onour I. (2009). Forward-Looking Beta Estimates: Evidence from an Emerging market, MPRA Paper No. 14992, www.mpra.ub.unimuenchen.de/14992/

  • Peter Christoffersen & Kris Jacobs & Gregory Vainberg (2007). Forward-Looking Betas, CREATES Research Papers 2007-39, School of Economics and Management, University of Aarhus.

  • Richards, Paul H. (2010). Deriving a ForwardLooking Equity Market Risk Premium, The Finance professionals' post, Article published on 04/27/2010

  • Santa-Clara, Pedro and Shu Yan (2010). Crashes, Volatility and the Equity Premium: Lessons from S&P 500 Options, The Review of Economics and Statistics, Vol 92, pp. 435-451.

  • Schroder. D (2005). The Implied Equity Risk Premium - An Evaluation of Empirical Methods, Bonn Graduate School of Economics, Bonn Econ Discussion Paper 13/2005.

  • Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk, Journal of Finance, Vol. 19, pp. 425-442.

  • Siegel, A. (1995). Measuring Systematic Risk Using Implicit Beta, Management Science, Vol. 41, pp. 124-128.

  • Wang, K. Q. (2003), Asset Pricing with Conditioning Information: A New Test, The Journal of Finance, Vol 58, pp 161-196.


Abstract Views: 490

PDF Views: 123




  • Equity Valuation: Premium to Interest Rate Structure Model

Abstract Views: 490  |  PDF Views: 123

Authors

Sandeep Keshava Rao
Business Schools, Bangalore, India

Abstract


Among the Equity Valuation models, the Discounting of cash flow (DCF) uses the cost of equity capital as a discounting rate in determining the value of equity. The cost of equity capital is usually calculated using the CAPM. The capital asset pricing model is backward looking as its components like beta and risk premium are based on the historical data. Most factor models used in academics and in practice consider historical data of stock returns and index to determine the cost of equity. The stock price which reflects the present value of future cash flows cannot be completely based on historical data for discounting. This paper proposes a modified model of DCF which takes into account a forward looking cost of equity capital. The model will include the time dynamic changes in the components of the cost of capital as opposed to those with time static components. It is proposed to use the forward looking risk free rate, obtained through bootstrapped spot curve, to which the forward looking time dynamic risk premium times the forward looking beta is added in order to arrive at the cost of equity. This forward looking cost of equity is then used for discounting of the estimated future cash flows to arrive at the value of the stock.

Keywords


Equity Valuation, Forward Looking Beta, Forward Looking Risk Premium.

References





DOI: https://doi.org/10.21842/pes%2F2016%2Fv11%2Fi1%2F108922