A radical, definitive explanation of the link between loss aversion theory, the equity risk premium and stock price, and how to profit from it The Risk Premium Factor presents and proves a radical new theory that explains the stock market, offering a quantitative explanation for all the booms, busts, bubbles, and multiple expansions and contractions of the market we have experienced over the past half-century.
Written by Stephen D. Hassett, a corporate development executive, author and specialist in value management, mergers and acquisitions, new venture strategy, development, and execution for high technology, SaaS, web, and mobile businesses, the book convincingly demonstrates that the equity risk premium is proportional to long-term Treasury yields, establishing a connection to loss aversion theory.
- Explains stock prices from 1960 through the present including the 2008/09 "market meltdown"
- Shows how the S&P 500 has consistently reverted to values predicted by the model
- Solves the equity premium puzzle by showing that it is consistent with findings on loss aversion
- Demonstrates that three factors drive valuation and stock price: earnings, long term growth, and interest rates
Understanding the stock market is simple. By grasping the simplicity, business leaders, corporate decision makers, private equity, venture capital, professional, and individual investors will fully understand the system under which they operate, and find themselves empowered to make better decisions managing their businesses and investment portfolios.
Table of Contents:
List of Figures xi List of Tables xiii
Preface xv
Evolution of a Theory xvi
Overview xvii
How This Book Is Structured xxi
As You Begin xxii
Acknowledgments xxiii
About the Author xxv
Chapter 1 Understanding the Simplicity of Valuation 1
Rates, Compounding and Time Value 3
Why Time Value Matters for the Stock Market 3
Valuing a Perpetuity 4
Constant Growth Equation: The Key to Understanding the Stock Market 5
Not the First to Try This 6
Why Growth Rate and Cost of Capital Matter 9
P/E Ratio Expansion and Contraction 10
CAPM, Risk Premium and Valuation 11
Equity Risk Premium 11
Impact of Risk Premium on Valuation 13
Chapter Recap 14
PART ONE Exploring the Risk Premium Factor Valuation Model
Chapter 2 The Risk Premium Factor Valuation Model 18
The RPF Model is Simple, but Does it Work? 21
Estimating the Risk Premium Factor (RPF) 24
Potential Causes for Shifts in the RPF 27
Potential Weaknesses in RPF Theory and Methodology 28
Adjusted Risk Free Rate 29
Comparison to the Fed Model 29
Chapter Recap 31
Chapter 3 Solving the Equity Premium Puzzle: The Link to Loss Aversion 33
Loss Aversion 34
Loss Aversion and Corporate Decision Making 34
Attempts to Solve the Equity Premium Puzzle 35
Impact of Inflation on Value 39
Back to Loss Aversion 39
Our Reptilian Brain 40
Chapter Recap 42
Chapter 4 The RPF Model and Major Market Events from 1981 to 2009 43
Efficient Market Hypothesis 44
How the RPF Valuation Model Explains Black Monday 45
2000 "Dot Com" Bubble: RPF Model Suggests Significant Bubble for the S&P 500 47
How the RPF Valuation Model Explains 2008-2009 Meltdown and Recovery 49
Markets Mostly Efficient and Rational, But Prone to Mistakes 52
Chapter Recap 53
PART TWO Applying the Risk Premium Factor Valuation Model
Chapter 5 Application to Market Valuation 57
Beware of Interest Rates 58
Example: Application to the Market in Late September 2009 59
Why the Source of Growth Matters 61
Chapter Recap 63
Chapter 6 Risk Adjusted Real Implied Growth Rate (RIGR) 65
Analyzing Individual Companies with RIGR 66
RIGR Analysis of Apple and Google Pre-Earnings Announcement 71
Chapter Recap 75
Chapter 7 Valuing an Acquisition or Project 77
Brief Introduction to Valuing an Acquisition or Project 78
Translating Your World View into Numbers 79
Setting the Cost of Capital 84
Example: Utility Acquiring a Risky Asset 86
Selecting the Investment Forecast Time Horizon 87
The All Important Terminal Value 89
Chapter Recap 96
Chapter 8 Case Study 1: Valuation of a High-Growth Business 99
Calculating Enterprise Value and Stock Price 107
Scenario Analysis 107
Chapter Recap 108
Chapter 9 Case Study 2: Valuation of a Cyclical Business 109
Chapter Recap 118
Chapter 10 Using the RPF Model to Translate Punditry 119
Read Carefully Then Analyze 119
What Have I Got to Lose? 120
Beware of Oversimplification 122
Confusing Headlines and Misguided Blame 123
Almost Nailed It 124
Graham and Dodd 125
The Wrong Discussion 127
Dumb Money and Bubbles 127
The Right Discussion 128
Chapter Recap 129
Chapter 11 Using the RPF Model for Investment and Business Strategy 131
Estimating Fair Value: How to Identify and Exploit Bubbles 132
Beware of RPF Shifts 137
Investing in Individual Companies 137
Reported Earnings Can Be Misleading 138
How to Apply the RPF Model to Day-to-Day Business Decisions 140
Capital Structure and Risk Impact Cost of Capital 141
Opportunistic Adjustments to Corporate Capital Structure 141
Creating a Sense of Urgency 142
Avoiding Value Destruction 143
Value Creation 145
Key Merger-and-Acquisition Valuation Concepts 147
Inflation Is the Enemy of Value 147
Final Thoughts 147
Appendix A Mobile Apps: The Wave of the Past 149
Appendix B Technology on the Horizon: What if Moore's Law Continues for Another 40 Years? 152
Appendix C A Simple and Powerful Model Suggests the S&P 500 Is Greatly Underpriced 156
Appendix D S&P Index Still Undervalued 160
Appendix E 30 Percent Value Gap in S&P 500 Closed by Rise in Treasury Yields, Price 163
Appendix F Making a Case for Salesforce.com Valuation 165
Glossary 169
Notes 171
About the Companion Website 177
Index 179
About the Author :
STEPHEN D. HASSETT is a corporate development executive with Sage North America, a subsidiary of The Sage Group plc, a leading global supplier of business management software and services. He has published in the Journal of Applied Corporate Finance and is a regular contributing author for the Seeking Alpha investment website. Previously, he was an executive at the Weather Channel, software entrepreneur and consultant with Stern Stewart & Co. He holds an MBA from the Darden School of Business at the University of Virginia.
