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ChoosingtheParameters:Disney

¨  Periodused:5years¨  ReturnInterval=Monthly¨  MarketIndex:S&P500Index.¨  Forinstance,tocalculatereturnsonDisneyinDecember2009,

¤  PriceforDisneyatendofNovember2009=$30.22¤  PriceforDisneyatendofDecember2009=$32.25¤  Dividendsduringmonth=$0.35(Itwasanex-dividendmonth)¤  Return=($32.25-$30.22+$0.35)/$30.22=7.88%

¨  ToesUmatereturnsontheindexinthesamemonth¤  IndexlevelatendofNovember2009=1095.63¤  IndexlevelatendofDecember2009=1115.10¤  DividendsonindexinDecember2009=1.683¤  Return=(1115.1–1095.63+1.683)/1095.63=1.78%

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Disney’sHistoricalBeta

!ReturnonDisney=.0071+1.2517ReturnonMarketR²=0.73386

(0.10)

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AnalyzingDisney’sPerformance

¨  Intercept=0.712%¤  Thisisaninterceptbasedonmonthlyreturns.Thus,ithastobe

comparedtoamonthlyriskfreerate.¤  Between2008and2013

n  AverageAnnualizedT.Billrate=0.50%n MonthlyRiskfreeRate=0.5%/12=0.042%n  RiskfreeRate(1-Beta)=0.042%(1-1.252)=-.0105%

¨  TheComparisonisthenbetween¤  Intercept versus RiskfreeRate(1-Beta)¤  0.712% versus 0.0105%¤  Jensen’sAlpha=0.712%-(-0.0105)%=0.723%

¨  Disneydid0.723%beaerthanexpected,permonth,betweenOctober2008andSeptember2013¤  Annualized,Disney’sannualexcessreturn=(1.00723)12-1=9.02%

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MoreonJensen’sAlpha

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127

¨  Ifyoudidthisanalysisoneverystocklistedonanexchange,whatwouldtheaverageJensen’salphabeacrossallstocks?a.  Dependuponwhetherthemarketwentupordownduringtheperiodb.  Shouldbezeroc.  Shouldbegreaterthanzero,becausestockstendtogoupmoreodenthandown.

¨  DisneyhasaposiUveJensen’salphaof9.02%ayearbetween2008and2013.Thiscanbeviewedasasignthatmanagementinthefirmdidagoodjob,managingthefirmduringtheperiod.a.  Trueb.  False

¨  DisneyhashadaposiUveJensen’salphabetween2008and2013.Ifyouwereaninvestorinearly2014,lookingatthestock,youwouldviewthisasasignthatthestockwillbea:a.  Goodinvestmentforthefutureb.  Badinvestmentforthefuturec.  NoinformaUonaboutthefuture

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EsUmaUngDisney’sBeta

¨  SlopeoftheRegressionof1.25isthebeta¨  RegressionparametersarealwaysesUmatedwitherror.TheerroriscapturedinthestandarderrorofthebetaesUmate,whichinthecaseofDisneyis0.10.

¨  AssumethatIaskedyouwhatDisney’struebetais,aderthisregression.¤  WhatisyourbestpointesUmate?

¤  Whatrangewouldyougiveme,with67%confidence?

¤  Whatrangewouldyougiveme,with95%confidence?

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TheDirtySecretof“StandardError”

Distribution of Standard Errors: Beta Estimates for U.S. stocks

0

200

400

600

800

1000

1200

1400

1600

<.10 .10 - .20 .20 - .30 .30 - .40 .40 -.50 .50 - .75 > .75

Standard Error in Beta Estimate

Num

ber o

f Firm

s

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BreakingdownDisney’sRisk

¨  RSquared=73%¨  Thisimpliesthat

¤  73%oftheriskatDisneycomesfrommarketsources¤  27%,therefore,comesfromfirm-specificsources

¨  Thefirm-specificriskisdiversifiableandwillnotberewarded.

¨  TheR-squaredforcompanies,globally,hasincreasedsignificantlysince2008.Whymightthisbehappening?

¨  WhataretheimplicaUonsforinvestors?

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TheRelevanceofRSquared

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131

¨  YouareadiversifiedinvestortryingtodecidewhetheryoushouldinvestinDisneyorAmgen.Theybothhavebetasof1.25,butDisneyhasanRSquaredof73%whileAmgen’sRsquaredisonly25%.Whichonewouldyouinvestin?¤  Amgen,becauseithasthelowerRsquared¤ Disney,becauseithasthehigherRsquared¤  Youwouldbeindifferent

¨  Wouldyouranswerbedifferentifyouwereanundiversifiedinvestor?

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BetaEsUmaUon:UsingaService(Bloomberg)

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EsUmaUngExpectedReturnsforDisneyinNovember2013

¨  InputstotheexpectedreturncalculaUon¤ Disney’sBeta=1.25¤  RiskfreeRate=2.75%(U.S.ten-yearT.BondrateinNovember2013)

¤  RiskPremium=5.76%(BasedonDisney’soperaUngexposure)

ExpectedReturn=RiskfreeRate+Beta(RiskPremium) =2.75%+1.25(5.76%)=9.95%

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UsetoaPotenUalInvestorinDisney

¨  AsapotenUalinvestorinDisney,whatdoesthisexpectedreturnof9.95%tellyou?¤  ThisisthereturnthatIcanexpecttomakeinthelongtermonDisney,

ifthestockiscorrectlypricedandtheCAPMistherightmodelforrisk,¤  ThisisthereturnthatIneedtomakeonDisneyinthelongtermto

breakevenonmyinvestmentinthestock¤  Both

¨  AssumenowthatyouareanacUveinvestorandthatyourresearchsuggeststhataninvestmentinDisneywillyield12.5%ayearforthenext5years.Basedupontheexpectedreturnof9.95%,youwould¤  Buythestock¤  Sellthestock

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Howmanagersusethisexpectedreturn

¨  ManagersatDisney¤  needtomakeatleast9.95%asareturnfortheirequityinvestorstobreakeven.

¤  thisisthehurdlerateforprojects,whentheinvestmentisanalyzedfromanequitystandpoint

¨  Inotherwords,Disney’scostofequityis9.95%.¨  Whatisthecostofnotdeliveringthiscostofequity?

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ApplicaUonTest:AnalyzingtheRiskRegression

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¨  UsingyourBloombergriskandreturnprintout,answerthefollowingquesUons:¤  Howwellorbadlydidyourstockdo,relaUvetothemarket,duringthe

periodoftheregression?¤  Intercept-(RiskfreeRate/n)(1-Beta)=Jensen’sAlpha

n  wherenisthenumberofreturnperiodsinayear(12ifmonthly;52ifweekly)

¤  WhatproporUonoftheriskinyourstockisaaributabletothemarket?WhatproporUonisfirm-specific?

¤  WhatisthehistoricalesUmateofbetaforyourstock?WhatistherangeonthisesUmatewith67%probability?With95%probability?

¤  Baseduponthisbeta,whatisyouresUmateoftherequiredreturnonthisstock?

¤  RisklessRate+Beta*RiskPremium

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AQuickTest

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¨  Youareadvisingaveryriskysodwarefirmontherightcostofequitytouseinprojectanalysis.YouesUmateabetaof3.0forthefirmandcomeupwithacostofequityof20%.TheCFOofthefirmisconcernedaboutthehighcostofequityandwantstoknowwhetherthereisanythinghecandotolowerhisbeta.

¨  Howdoyoubringyourbetadown?

¨  ShouldyoufocusyouraaenUononbringingyourbetadown?¤  Yes¤  No

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RegressionDiagnosUcsforTataMotors

Beta = 1.8367% range1.67-1.99

Jensen’s α= 2.28% - 4%/12 (1-1.83) = 2.56% Annualized = (1+.0256)12-1= 35.42%Average monthly riskfree rate (2008-13) = 4%

69% market risk31% firm specific

Expected Return (in Rupees)= Riskfree Rate+ Beta*Risk premium= 6.57%+ 1.83 (7.19%) = 19.73%

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Abeaerbeta?Vale

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DeutscheBankandBaidu:IndexEffectsonRiskParameters

Aswath Damodaran

¨  ForDeutscheBank,awidelyheldEuropeanstock,wetriedboththeDAX(Germanindex)andtheFTSEEuropeanindex.

¨  ForBaidu,aNASDAQlistedstock,weranregressionsagainstboththeS&P500andtheNASDAQ.