Brigham Xtra!

Using Past Information to Estimate Required Returns

Overview

In this chapter, we discussed the basic tradeoff between risk and return. In our discussion of the Capital Asset Pricing Model (CAPM) we stressed that beta is the correct measure of risk for diversified shareholders. Recall that beta measures the extent to which the returns of a given stock move with the stock market. When using the CAPM to estimate required returns, we would ideally like to know how the stock will move with the market in the future, but since we don't have a crystal ball we generally use historical data to estimate beta. As we mention in the Web Appendix for this chapter, we can estimate beta by regressing the individual stock's returns against the returns of the overall market. As an alternative to running our own regressions, we can instead rely on reported betas from a variety of sources. These published sources make it easy for us to readily obtain beta estimates for most large publicly traded corporations. However, a word of caution is in order. Beta estimates can often be quite sensitive to the time period in which the data is estimated, the market index used, and whether or not we use daily, weekly, or monthly data. Therefore, it is not uncommon to find a wide range of beta estimates among the various published sources. Indeed, Thomson Analytics reports multiple estimates of beta. These multiple estimates reflect the fact that Thomson Analytics puts together data from a variety of different sources.

Discussion Questions

1. Begin by taking a look at the historical performance of the overall stock market. If you want to see, for example, the performance of the S&P 500, select INDEXES and then enter S&PCOMP. Click on PERFORMANCE and you will immediately see a quick summary of the market's performance in recent months and years. How has the market performed over the past year? The past three years? The past 10 years?

2. Now let's take a closer look at the stocks of four companies: Colgate Palmolive (Ticker = CL), Gillette (G), Merrill Lynch (MER), and Microsoft (MSFT). Before looking at the data, which of these companies would you expect to have a relatively high beta (greater than 1.0) and which of these companies would you expect to have a relatively low beta (less than 1.0)?

3. Select one of the four stocks listed above by selecting COMPANIES and entering the company's ticker symbol, which was given above. On the overview page, you should see a chart that summarizes how the stock has done relative to the S&P500 over the past six months. Has the stock outperformed or underperformed the overall market during this time period? To look at the stock's performance over a longer time period, click on INTERACTIVE CHART and select a 5-year time frame and click on DRAW for the chart to be updated. Has the company outperformed or underperformed the S&P 500 over the past five years? Looking at the chart, which has had more volatility over the past five years, this company's stock or the overall market? You can repeat this exercise for each of the remaining three companies. Also, in the interactive chart you can plot the stock prices of each of these companies relative to the market on the same chart. (To do this, click on the arrows to the right of the COMPARE TO line and add the ticker symbols (separating them by commas) for the stocks not already shown on the chart. Then click DRAW for the chart to be redrawn.)

4. Return to the overview page for the stock you selected. If you scroll down the page you should see an estimate of the company's beta. What is the company's beta? What was the source of the estimated beta?

5. Click on the tab labeled PRICES. What is the company's current dividend yield? What has been its total return to investors over the past six months? Over the past three years? (Remember that total return includes the dividend yield plus any capital gains or losses.)

6. What is the estimated beta on this page? What is the source of the estimated beta? Why might different sources produce different estimates of beta? (Note if you want to see even more beta estimates, click OVERVIEWS and then select the SEC DATABASE MARKET DATA. Scroll through the STOCK OVERVIEW SECTION and you will see a range of different beta estimates.)

7. Select a beta estimate that you think is best. (If you are not sure, you may want to consider an average of the given estimates.) Assume that the risk-free rate is 5 percent and the market risk premium is 6 percent. What is the required return on the company's stock?

8. Repeat the same exercise for each of the three remaining companies. Do the reported betas confirm your earlier intuition? In general, do you find that the higher-beta stocks tend to do better in up markets and worse in down markets?

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