How to estimate an Implied Equity Risk Premium. The case of the Moroccan All Shares Index (MASI)

The Equity Risk Premium (ERP) is the extra return an investor requires for investing in stocks rather than risk-free assets, compensating him for taking on the relatively higher risks associated with equities. In practice, it is the return of a stock index representing the market portfolio, minus a risk-free asset, typically the 10-year government bond:

Equity Risk Premium = Expected return on the market – risk-free rate

The more pessimistic investors are about the market, the higher the risk premium will be. Depending on the estimation approach, equity risk premium can be historical, implied, or based on surveys of investors, portfolio managers, and CFOs. In this article, which is an excerpt from my book (https://www.amazon.com/BANK-VALUATION-DEMYSTIFIED-practical-real-world/dp/B085KJS7D9/ref=sr_1_6 keywords=bank+valuation&qid=1583872100&sr=8-6 ), we will focus on the Implied ERP. 

While the historical ERP is estimated based on historical data, the implied ERP estimation approach is based on future data. It is estimated through a dividend discount model in order to calculate an implied cost of equity based on the price level of the index. We will need to estimate future dividends or free cash flows-to-equity using the Gordon growth model, the two-stage model, or the three-stage model, depending on our views on the index, and then solve for the implied cost of equity.

Simplistically, the formula for the implied cost of equity is:

Where the t is the time from now to infinity, the market value of the index is the level of the index, the cash flow is the expected dividends and buybacks of the index, the implied cost of equity – the only "unknown” in the formula – is calculated by solving for Ke. Then, the implied ERP is calculated by deducting the risk-free rate from the implied cost of equity: 

Implied ERP = Implied cost of equity – 10-year government bond yield

Note that the implied ERP is not multiplied by beta as the beta of a broad index portfolio equals one by construction.

Illustration:

Let us take the Moroccan All Shares Index (MASI) as a proxy for the broad stock market of Morocco. To estimate the implied equity risk premium, we will use a three-stage model.


We look at dividends as a percentage of the index from 2009 to 2018 in order to get normalized dividends. As we can see in the table below, the dividends averaged 3.75% of the index each year:

    Table 2.21: Dividends on MASI Index from 2009 to 2018

Applying the 3.75% yield to the current market value of the index (11 113.87 as of 04/19/2019) results in normalized dividends of 416.3 index points:

Normalized dividends = 3.746% x 11 113.87 = 416.3

 We will assume that dividends grow 5% during the first stage and gradually converge at 3% in 2028. For the terminal value, we will use a growth rate of 3%.

The expected dividends over the next years can be seen in the table below: 

Table 2.22:  The estimation of expected dividends in the next ten years on MASI Index 

Based on the expected dividends and the actual price level of the index, we will solve (using Excel Solver) for the implied cost of equity in the following equation:

Then, the implied ERP is calculated netting out the risk-free rate from the implied cost of equity:

Table 2.23: The estimation of MASI’s Implied Equity risk premium:

Note that we could have gotten a higher implied ERP if we had taken buybacks into account.

The advantage of the implied ERP is that it is forward-looking and does not rely heavily on historical data. For this reason, it is consistent with the methodology used in DCF models. It is implied from equity market values, reflecting the reality of the market as we included the current level of the index and the risk-free rate. Finally, it is consistent with the efficient market hypothesis[1], which implies that prices fully reflect all available information about a particular stock or market or both. However, the implied ERP is highly dependent on the estimation of future dividends and cash flows, numbers that are sometimes unpredictable in emerging markets.

SOURCE: ZARGUI, H (2020). BANK VALUATION DEMYSTIFIED, a practical guide with real-world case studies available at https://lnkd.in/gPmXQUE

How to value a declining firms : Macy's Inc - August 2018

A BRIEF PRESENTATION

Macy’s Inc is an american classic when it comes to retail. It sells a wide range of merchandise, including apparel and accessories (men’s, women’s and children’s), cosmetics, home furnishings and other consumer goods. The specific assortments vary by size of store, merchandising assortments and character of customers in the trade areas. Most stores are located at urban or suburban sites, principally in densely populated areas across the United States[1]. The company was formerly known as Federated Department Stores, Inc. and changed its name to Macy's, Inc. in June 2007. Macy's, Inc. was founded in 1830 and is based in Cincinnati, Ohio.

Macy’s Inc is becoming a declining company and this is reflected into its decreasing revenues accompanied by shrinking operating margins as showed in the graph below. In fact, as consumers continue to migrate online, Macy’s Inc and traditional retailers are reeling. Some are being forced to shrink — or go out of business altogether.

After shuttering dozens of stores in 2016, Macy’s began 2017 by announcing plans to close 68 more of its locations, including a store in downtown Minneapolis that opened in 1902. The company estimates that 3,900 jobs will be lost as a result of the closures. This is reflected into its capital invested which continues to decline as showed in the graph below:

VALUATION:  MACY’S INC 2017

To value a declining company such as Macy’s, we will assume that the firm, while not in distress, will close its locations as it continues to experience declining traffic in their stores.

Thus, we assume that revenues will decrease 2.3% on average a year, each year for the next 7 years to $21.9 billion in the seventh year, as the firm shuts down stores. After 2025, we will assume that the company will recover and that revenues will grow 0.9% on average until 2027 and 1.5% a year forever.

The pre-tax operating margin will improve from 5.10% to 8% over the next years, reflecting both the cost savings from shutting down unprofitable stores and a reversal back to health at the other stores.

Taxes: For the first five years we’ll use the current effective tax (35.8%) that will converge gradually on 30%, the marginal tax rate for the US as tax code changes.

In terms of risk, we will use for the first five years, the current cost of capital for Macy’s Inc, which we estimate to be 6.44%.

	high growth	Stable Growth
10 years US bonds	2.29%	2.29%
ERP	5.13%	5.13%
Beta	1.38	1
Ke	9.36%	7.42%
E/E+D	51%	65%
Kd(1-t)	3.43%	3.43%
D/E+D	49%	35%
WACC	6.44%	6.02%

During the 2017-2020 period, as stores are being reconfigured or closed and assets divested, Macy’s will shorten its capital invested and collect proceeds from the divestitures. We estimated the proceeds as percentage of change in capital invested over the next four years based on the assumption that the Return on invested capital will converge to 13% over the next 10 years. The table below reports the numbers by year:

We assume that the divestitures proceeds, as a percentage of book value, will be 40% in 2017 and that divestitures will end in 2020.

To close the valuation, we estimated the terminal value based on a growth rate of 1.5%, a return on capital that equals the cost of capital on the long term phase ( we assume that Macy’s will earn its cost of capital).

Reinvestment Rate = g stable / ROCE stable   = 1.5%/ 6.02%   = 24.9%

Terminal Value =   Operating income *(1-t) * (1+g)*(1-reinvestment rate) / ( WACC-g)

                                           =   1 260 * (1+1.5%) * (1-24.9%) / (WACC-g) = 20 980

The table below underlines the free cash flows generated over the next 10 years:

Summing the present value of the free cash flows over the next 10 years and the terminal value’s present value yield a value of $21 966 billion. Adding cash ($1 297 billion), subtracting out debt ($7 720 billion), debt value of leases ($2 612 billion), pension obligations ($1 028 billion), minority interests (-$1 billion) yields and dividing by the number of shares outstanding (304) yields a value per share of USD 39.15. Taking into consideration the probability (90%) that this scenario will take effect yields an adjusted value per share of USD 35.24, 59.5% higher than the share price as of 08/08/2017.

"A picture is worth a thousand words"

---

[1] Macy’s Inc 2016 annual report

Ø  Aswath Damodaran (2015),  Applied Corporate Finance, 4th Edition