Estimating the Required Return on a Stock Using the Bond-Yield Plus Risk Premium Method
Theoretical asset valuation models such as the Capital Asset Pricing Model and Arbitrage Pricing Theory do not always work in practice. In 2002 the telecom bubble was beginning to burst, and the bonds for heavily leveraged telecom companies started to signal financial distress, with yields to maturity (YTM) rising to 20% or more. At the same time, equity analysts were frequently valuing the stocks on the basis of the CAPM and a cost of equity of perhaps 15%.
Since equity holders have a residual claim equity investors are assumed to demand a higher return than bondholders. Therefore, a 15% required equity return when bonds are yielding 20% does not make economic sense. Instead, the results of the CAPM model could have been checked against the bond YTM and adjusted to reflect a risk premium to the same company’s publicly traded bonds.
Historical equity to bond premia have been 3-4%, though investors may want to use a higher premium in times of financial distress.
For more information, see all articles on: Investing in Stocks, Investment Returns, Portfolio Management, Security Selection, Valuation See also:
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
