Company Valuation Under IFRS : Interpreting and Forecasting ...

Company valuation under IFRS
Exhibit 2.9: Estimating Betas
Estimating Betas
Usually by regression analysis:
x
x
x
x
x
x
x
x
R s
x
x
x
x
x
x
x
x
x
x
x
x
x
β= slopeof line
R m
α = Abnormal Return
2.4 What is the Market Risk Premium?
Let us return again to Exhibit 2.6. An assumption that underlies it is that the
market portfolio is expected to offer a higher return than a risk free asset. This is
clearly sensible. While investors can diversify away all the specific risks to which
equities are exposed, they cannot diversify away market risk, so they must be
compensated for assuming it. Once we know what the price of market risk is,
then we can draw the capital market line, and use it to read off the required return
for any individual equity. But where do we get the market risk premium from?
As with Betas, one approach is to look at history. Data have been collected (in
the UK in the form of the Equity-Gilt Study and more recently by the London
Business School, in the USA by Ibbotson) that compare returns on different asset
classes annually. There is a technical question that arises when doing this
exercise. Should each year be treated as an individual entity, and the annual
returns be arithmetically averaged, or should the whole period of decades be
treated as a single entity, in which case the annual return derived will be a
geometric average? We tend to the latter view, but would note that as with Betas
the more crucial question is whether the expected future figures are the same as
the actual historical ones.
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