Required Returns, the Market Risk Premium, and Historical Returns

5 Pages Posted: 12 Jun 2009

See all articles by Robert S. Harris

Robert S. Harris

University of Virginia - Darden School of Business

Abstract

This technical note discusses the use of historical returns as a guide for estimating forward-looking required returns on equity. The note discusses uses of short- and long-term interest rates plus equity risk premia based on averages (either arithmetic or geometric) of past returns.

Excerpt

UVA-F-1022

REQUIRED RETURNS, THE MARKET RISK PREMIUM,

AND HISTORICAL RETURNS

The required return appropriate to discount cash flows depends on the riskiness of those flows. While an individual can (and sometimes must) make subjective judgments about risk and required return in order to estimate market value, we must look to market required returns. For example, in the case of bonds, the required return, Kd, is the yield to maturity that the company would have to pay if it issued new debt.

Unfortunately, we cannot directly observe a comparable figure for equity for two reasons: 1) unlike debt, equity is not a contractual claim, and 2) equity has no maturity. In principle, what we desire is the required return of equity owners in the firm. Unfortunately, asking the shareholders directly is not feasible, so we must infer such a required return. One method of doing so is to use the dividend-growth model to estimate what return shareholders expect in the future. While useful, however, the dividend-growth model provides no explicit framework for seeing how risk affects required returns. Furthermore, estimation of expected growth rates is difficult.

An alternative model is the capital asset pricing model (CAPM), which shows how increased risk, in terms of an increased beta, leads to higher required returns. However, the CAPM is, at best, an approximation of what happens in financial markets and focuses on a one-period horizon, as shown in Equation 1.

. . .

Keywords: cost of capital, financial analysis, valuation

Suggested Citation

Harris, Robert S., Required Returns, the Market Risk Premium, and Historical Returns. Darden Case No. UVA-F-1022, Available at SSRN: https://ssrn.com/abstract=1418333

Robert S. Harris (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4823 (Phone)
434-924-4859 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/harris.htm

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