Equity Asset Valuation, Second Edition

CHAPTER 2

RETURN CONCEPTS

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following :

• Distinguish among the following return concepts: holding period return, realized return and expected return, required return, discount rate, the return from convergence of price to intrinsic value (given that price does not equal value), and internal rate of return.

• Explain the equity risk premium and its use in required return determination, and demonstrate the use of historical and forward-looking estimation approaches.

• Discuss the strengths and weaknesses of the major methods of estimating the equity risk premium.

• Explain and demonstrate the use of the capital asset pricing model (CAPM), Fama-French model (FFM), the Pastor-Stambaugh model (PSM), macroeconomic multifactor models, and the build-up method (including bond yield plus risk premium method) for estimating the required return on an equity investment.

• Discuss beta estimation for public companies, thinly traded public companies, and nonpublic companies.

• Analyze the strengths and weaknesses of the major methods of estimating the required return on an equity investment.

• Discuss international considerations in required return estimation.

• Explain and calculate the weighted average cost of capital for a company.

• Explain the appropriateness of using a particular rate of return as a discount rate, given a description of the cash flow to be discounted and other relevant facts.

1. INTRODUCTION

The ...