In the preceding chapter, we considered that equity holders anticipate a higher rate of return than debt holders. The exact degree to which this return should be greater is what we will use to discount the free cash flow to the equity holders. So then, what number should this premium encompass?
Considering the risk-free rate to be 7%, how much more return should you demand from investing in equities to make it worth your effort? An average is usually estimated by a group of investors; however, most individuals are unable to obtain this consensus. Therefore, we need to use an equation to get a satisfactory estimation.
Re = Risk free rate (Rf) + Risk premium
Where Re = Return expectation of equity holders.
The risk premium is the extra return investors are rewarded with if they choose to invest in equities, above and beyond a risk-free return.
Risk premium = β*(Rm – Rf), where
Rf = Risk-free rate
Β = Beta of the stock
Rm = Market rate
Of course, we can rearrange the Re equation –
Re = Rf + β*(Rm – Rf)
This equation in finance is referred to as ‘The Capital Asset Pricing model’, or CAPM.
Let’s take a look at how this works with an example. The 10-year Government bond yield is widely considered the best substitute for the risk-free rate and can be easily accessed from the CCIL portal.
I highlighted the 10-year Government bond maturing in 2032, whose yield stands at 7.4586%. An investment in this bond would present a return of 7.4586% without any danger, as the Government of India is highly unlikely to default on its debt commitments.
Defaulting on debt is a very serious matter, so governments do their utmost to avoid it. With this in mind, why are we looking at bonds with a ten-year maturity rather than shorter? This is because longer-term yields are of greater interest and we need to predict free cash flows for the foreseeable future.
Next up is Beta. If you are unfamiliar with the concept, I suggest reviewing section 11.5 of this chapter, which explains its stock price sensitivity relative to the stock market.
The market rate is Rm, and its long-term average gain can be pegged around 8% to 9%, though you might want to bump it up to 10 or 12% if you’re feeling optimistic.
Please be advised that the final model may incorporate whichever rates you deem best. We shall presume that the Beta of the organization under consideration is higher risk than the general market, thus assigning a value of 1.3.
Let us use Excel to quickly ascertain the Beta of a company and analyze the return expectation for its equity holders. Plugging in the numbers should provide us with a better insight.
= 7.4586% + (1.3) * (8.5%-7.4586%)
If you wish to adjust any values within our model, you are able to do so. There have to be rationalisations for the alterations, but feel free to switch the risk-free rate from 7.45% to 8%, for instance.