Beyond Earnings

7RISK, REWARD, AND THE HOLT DISCOUNT RATE

“Assets are bundles of factors, each of which defines a set of bad times for the average investor. Over the long run, investors exposed to factors earn high returns. But there is risk. There are superior returns to factors, on average, because during bad times they can underperform—sometimes dramatically. Factor premiums also result from the behavior of investors that is not arbitraged away.”

—Andrew Ang¹

KEY LEARNING POINTS

• Risk is the potential for loss and has two sources: systematic and unsystematic. Systematic risk is market risk and cannot be diversified away. Unsystematic risk is idiosyncratic and can be diversified away by owning a portfolio of assets. Investors should not expect to be rewarded for unsystematic risk.
• The long‐run inflation‐adjusted return on U.S. equities has been circa 6% versus 2% for U.S. Treasury bonds. Equity investors expect a greater return due to more risk. The equity risk premium (ERP) is the difference between equities and government bonds, and varies with risk appetite. The long‐run geometric and average ERPs for the world are 3.2% and 4.4%, respectively. The valuation of future cash flows should use an arithmetic ERP when estimating the cost of equity.
• HOLT calculates a forward‐looking cost of capital and adjusts it with firm‐specific risk factors. It is a total system approach to valuation because the discount rate is tuned to future cash flow assumptions. The discount rate level indicates ...