I’m doing some work with the Capital Asset Pricing Model, trying to derive a cost of capital for my firm.
Back in my B-school days we used 12% as the historical risk premium in the model (nominal, 9% real). Given the recent performance in the market(3-4 years), are folks using a higher number these days?
The only justification I could see for this would be the overall level of risk in the market getting cranked up a notch, which may have very well happened.
At any rate, any opinions of different #'s or should I go with the 12%.
What kind of benchmark do you need? It can’t be too hard to calculate a, say, 10 year market premium (e.g. 1991-2000) based on T-bill rates and average Dow Jones Growth per annum. Your superiors will love the initiative.
Besides, CAPM alone isn’t the greatest estimator for a companies cost of capital, I’d say. Are you using your industry bèta?
Have you considered expanding your calculations to WACC?
Let’s leave EVA out of it for now - I’m assuming you want a quick and dirty answer.
I finished B-school 2 years ago and I believe that 12% was the assumption we used. Of course, it would be pretty easy to measure. Just use the CAGR of the S&P over the past few decades. But keep in mind that using any index overstates the risk premium. This is because many companies have gone out of business throughout history and their (negative) returns are never included in any market premium calculation.
Also, since you’re using the CAPM, you’re assuming reasonably efficient markets. Therefore, I recommend not going too far back in history for your calculation. The markets were not very efficient in the '20s and '30s. I would probably begin my return calculation in the '50s or '60s.
BTW, I’ve assumed that you know how to perform the calculation using your company’s equity beta and have a good idea on where to find the risk-free rate of return.
Thanks for the suggestion I calculate it myself. Remind me never to ask a question about the relationship between pressure and volume of a gas, you guys would have me go re-derive Boyle’s law.
A couple of things -
Colfire suggests using the DJ as the market returns - bad idea for a number of reasons as the S&P is superior (primarily the risk makeup of portfolio, and the fact that the S&P is value weighted, not share weighted). Also, the past 10 years don’t represent a full business cycle(peak to peak, or for the pessimists, trough to trough).
Also, not that it matters, but the whole reason for the need for the market risk premium is to feed the CAPM, to feed the WACC calculation to perform EVA. Hey, I know all the acronyms too.
Jackknife, I remember the "out of business’ objection to the model vaguely, but it seems to me that the reduced value in those stocks would have been seen in the market as they went out of business, falling nearly to zero before trading is stopped. Is there more to it than that?
Thanks for letting me know they were still using 12% two years ago. Given that the recent market has yet to go through a full business cycle, there is probably no compelling evidence to recalculate the premium.
There’s not much more to it as long as you realize the weaknesses of using an index. The S&P 500 only the includes the 500 largest companies with the most liquid stocks in the market. Once a company fails to achieve these criteria, it falls out of the S&P. Undoubtedly, only the successful companies will be able to maintain these requirements and remain in the index. Therefore, a “bad” company can no longer have the negative impact on the market premium that it should. You were correct in pointing out the weaknesses with using the price-weighted DJIA, but other indices have weaknesses too. Theoretically, the true “Market Premium” would be the premium offered by an equally-weighted investment in every possible investment in the world including Microsoft, South African real estate, Indian steel, GE, New York municipal bonds, etc. Clearly, its impossible to find an index that includes all of these.
And good luck! EVA always seems so simple in theory, but in practice is diffucult to use. I mean its easy to calculate the WACC and the invested capital, but it becomes difficult to assess how much control managers have over the components of invested capital. And when bonuses are based on EVA, people will question every assumption you make.
Oh I am well aware of the pitfalls of EVA, the biggest problem I’ve found is that the AR and AP accounts are too aggregated to accurately split between SBU’s.
