Ibbotson Risk Premia: Under

the Microscope
Michael W. Barad
Ibbotson Associates
ASA/CICBV 5th Joint Business Valuation Conference
Orlando, Florida
October 24, 2002
Overview

z Cost of Capital / Cost of Equity

– Equity Risk Premium

– Size Premium

– Industry Premium

Copyright © 2002 Ibbotson Associates, Inc. Page 2

Cost of Capital

z The cost of capital is the discount rate that should be used to derive
the present value of an asset’s future cash flows.
z The weighted average cost of capital (WACC) is the average
required rate of return of all the company’s financing, equity, debt,
and preferred stock, weighted in proportion to the company’s total
invested capital.

WACC = WDkD(1-t) + WEkE

WD, WE = Weights of debt and equity respectively for the firm

kD = Cost of Debt
kE = Cost of Equity (can be estimated by Buildup Method or CAPM)
t = tax rate

Copyright © 2002 Ibbotson Associates, Inc. Page 3

Cost of Equity

z Buildup Method
Risk Free Rate
+ Equity Risk Premium
+ Size Premium
+ Industry Premium
+ Other Factors?
Cost of Equity

z Capital Asset Pricing Model (CAPM)

Cost of Equity = Rf + β (ERP) + SP

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Equity Risk Premium

z Definition
– The expected equity risk premium is defined as the additional
return an investor expects to receive to compensate for the
additional risk associated with investing in equities as opposed to
investing in riskless assets

– Excess return of stocks over bonds

z Ibbotson Calculation
– ERP = (arithmetic mean total return of stocks) - (arithmetic mean
income return of a risk-free asset)

Copyright © 2002 Ibbotson Associates, Inc. Page 5

Issues with Calculating ERP

z Stock Market Benchmark and Risk-Free Asset

– S&P 500
– 20 Year Government Bond

z Arithmetic verses Geometric Average

z Time period for measurement

Copyright © 2002 Ibbotson Associates, Inc. Page 6

 Equity Risk Premium

-60%
-40%
-20%
0%
20%
40%
60%
1926
1929
1932
1935
1938
1941
Realized Annual ERP

1944

Copyright © 2002 Ibbotson Associates, Inc.

1947
1950
1953
Equity Risk Premium

1956
1959

Page 7
1962
1965
1968
1971
1974
1977
1980
1983
1986
1989
1992
1995
1998
2001
 Average ERP through 2001

19

0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
26
19
29
19
32
19
35
19
38
19
41
19
44

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19
Different Starting Dates

47
19
50
19
53
19
Equity Risk Premium

56
19
59
19

Page 8
62
19
65
19
68
19
71
19
74
19
77
19
80
19
83
19
86
19
89
19
92
19
95
Equity Risk Premium
Alternative Calculation Techniques

z Survey Results

z Supply-Side

z Demand-Side

z Exponential Weighting

Copyright © 2002 Ibbotson Associates, Inc. Page 9

Size Premium
Cost of Equity Models

z Buildup Method
Risk Free Rate
+ Equity Risk Premium
+ Size Premium
+ Industry Premium
+ Other Factors?
Cost of Equity

z Capital Asset Pricing Model (CAPM)

Cost of Equity = Rf + β (ERP) + SP

Copyright © 2002 Ibbotson Associates, Inc. Page 10

Size Premium
Explanation of Terms

z Size Premium (beta-adjusted)

– The return on small company stocks in excess of that predicted by
the CAPM. It is the additional return that cannot be explained by
the betas of small companies.

z Small Stock Premium (non-beta-adjusted)

– The excess return of small company stocks over large company
stocks.

Copyright © 2002 Ibbotson Associates, Inc. Page 11

Size Premium

Steps to identifying an appropriate size premium:

z Classify your company
– Public vs. Private
– Market Cap or Equivalent

z Which decile does the company fit into?

z Locate a size premium for the corresponding decile

Copyright © 2002 Ibbotson Associates, Inc. Page 12

Size Premium
Private company market capitalization equivalent

Companies Without Market Capitalization Data

– Market Capitalization Equivalent
• Financial Ratios
– Example with the Price/Sales ratio for a company in the food stores
industry, SIC 54
• Sales for Company A are $200 million
 P 
• The P/S ratio for SIC 54 is 0.40  200 = 0.40
• 0.40 x $200 million = $80 million
– Example with P/CF ratio for the same company
• The Cash Flow is $10 million
 P 
• The average P/CF for SIC 54 is 18.0  10. = 18.0
• 18.0 x $10 million = $180 million

Copyright © 2002 Ibbotson Associates, Inc. Page 13

Size-Decile Breakpoints
From the SBBI Valuation Edition 2001 Yearbook
Market Cap of Largest
Decile Company (in thousands)
1 - Largest $524,351,578
2 10,343,765
3 4,143,902
Market Cap of Largest
4 2,177,448
Decile Company (in thousands)
5 1,327,582
10a 84,521
6 840,000 10b 48,345
7 537,693
8 333,442
9 192,598
10 - Smallest 84,521

Mid-Cap, 3-5 Capitalization between $840 and $4,144million

Low-Cap, 6-8 Capitalization between $192 and $840 million
Micro-Cap, 9-10 Capitalization below $192 million

Copyright © 2002 Ibbotson Associates, Inc. Page 14

Size Premium
Calculation

z Return in Excess of CAPM

ks = rf + β (ERP)

– Run a CAPM regression to determine the beta of each

size decile

– CAPM estimates that smaller stocks will have higher

returns to go along with their higher betas
• Smaller stocks should and do have higher returns
• CAPM estimates vs. historical returns
– Smaller stocks have had returns that are not fully explained
by their higher betas

Copyright © 2002 Ibbotson Associates, Inc. Page 15

 Size Premium Table
From the SBBI Valuation Edition 2001 Yearbook
Realized Estimated Size Prem
Return in Return in (Return in
Arithmetic Excess of Excess of Excess of
Decile Beta Mean Return Riskless Rate Riskless Rate CAPM)
1-Largest 0.91 12.06% 6.84% 7.03% -0.20%
2 1.04 13.58% 8.36% 8.05% 0.31%
3 1.09 14.16% 8.93% 8.47% 0.47%
4 1.13 14.60% 9.38% 8.75% 0.62%
5 1.16 15.18% 9.95% 9.03% 0.93%
6 1.18 15.48% 10.26% 9.18% 1.08%
7 1.24 15.68% 10.46% 9.58% 0.88%
8 1.28 16.60% 11.38% 9.91% 1.47%
9 1.34 17.39% 12. 17% 10.43% 1.74%
10-Smallest 1.42 20.90% 15.67% 11.05% 4.63%

Mid-Cap, 3-5 1.12 14.46% 9.23% 8.65% 0.58%

Low-Cap, 6-8 1.22 15.75% 10.52% 9.45% 1.07%
Micro-Cap, 9-10 1.36 18.41% 13.18% 10.56% 2.62%

Copyright © 2002 Ibbotson Associates, Inc. Page 16

Derivation of the Size Premium
Realized Estimated Size Prem
Return in Return in (Return in
Arithmetic Excess of Excess of Excess of
Decile Beta Mean Return Riskless Rate Riskless Rate
CAPM)
Realized -
Historical Return Return - Riskless Rate Beta x ERP
Estimated
(20.90%) (20.90% - 5.22%) (1.42 x 7.76)
15.67% - 11.05% = 4.63%

10-Smallest 1.42 20.90% 15.67% 11.05%

4.63%

Riskless Rate = Arithmetic mean income return on the U.S. LT Gvt Bond (5.22%)
ERP = Arithmetic mean total return of the S&P 500 (12.98%) minus the arithmetic mean income return
on the U.S. LT Gvt Bond (5.22%) = 7.76%

Copyright © 2002 Ibbotson Associates, Inc. Page 17

Size Premium
Graphical Representation

Security Market Line versus Size-Decile Portfolios of the NYSE/AMEX/NASDAQ

25%

10
20%
9
8
56 7
Arithmetic Mean Return

15% 3 4
2
1
S&P 500
10%

5% Amount by which actual

Riskless Rate
returns have outperformed
what a pure CAPM would
0% estimate
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6
Beta

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Size Premium Comparison
Beta-adjusted vs. non-beta-adjusted

z Ibbotson provided non-beta-adjusted size premia up

through the Stocks, Bonds, Bills, and Inflation 1994
Yearbook
– (small stock return - large stock return)
– Also referred to as small stock premium

z Ibbotson has provided beta-adjusted size premia starting

in the SBBI 1995 Yearbook through the present
– Return in excess of CAPM

Copyright © 2002 Ibbotson Associates, Inc. Page 19

Size Premium

z Non-Beta-Adjusted
– Using a non-beta-adjusted size premium assumes that
the company being valued has the same systematic
risk (or beta) as the portfolio of small stocks used in
the calculation of the size premium

– Different industries tend to have different levels of

systematic risk
• Companies within the food stores industry tend to have less
systematic risk than the market. By using the historical return
on small stocks to develop a non-beta-adjusted size premium
you would be assuming that a small food stores company has
the same risk as the portfolio of all small stocks across any
industry

Copyright © 2002 Ibbotson Associates, Inc. Page 20

Size Premium

z Beta-Adjusted
– A beta-adjusted size premium isolates the excess
return due to size, so it can be applied to a company
without making any assumptions regarding the
company’s systematic risk

– Adding a size premium independent of systematic risk

allows the addition of other factors that do account for
risk without overlap
• Buildup Method
– An industry premium can be added to account for industry specific
risk
• CAPM
– The beta used in a CAPM can account for certain risk factors inherent
to the company itself or the industry of its peers
Copyright © 2002 Ibbotson Associates, Inc. Page 21
Industry Risk Premia

z Ibbotson Associates calculates industry premia for

almost 300 industries
– For use in the buildup method
• Same as using an industry beta, but in the context of the
buildup

– Many are negative

– Full information approach is used (FI beta)

• IRP = (RI x ERP) - ERP
– RI = the risk index for a particular industry (FI Beta)
– ERP = the expected equity risk premium
– Example for the food stores industry, SIC 54
• IRP = (0.36 x 7.8) - 7.8 = -5.0%
Copyright © 2002 Ibbotson Associates, Inc. Page 22
Industry Premium
Range of premia presented in the SBBI Valuation Edition Yearbook

90
# of Industries Within Each Range

80
70
60
50
40
30
20
10
0
%

%
0%

2%

4%

6%

8%
-8

-6

-4

-2

10

12

14

16
Industry Premium

Copyright © 2002 Ibbotson Associates, Inc. Page 23

 Industry Premium
Full information example - household appliance industry

% of Industry
Sales to Total Sales to Total Full
SIC 363 Company Company % of Sales to Pure Play Information
Company Name ($Mil) Sales ($Mil) Sales SIC 363 Member Member
APPLICA INC $ 715 $ 715 100.0% 2.7% Yes Yes
HMI INDUSTRIES INC $ 32 $ 32 100.0% 0.1% Yes Yes
NATIONAL PRESTO INDS INC $ 117 $ 117 100.0% 0.4% Yes Yes
SALTON INC $ 792 $ 792 100.0% 3.0% Yes Yes
WHIRLPOOL CORP $ 10,343 $ 10,343 100.0% 39.1% Yes Yes
ROYAL APPLIANCE MFG CO $ 407 $ 428 94.9% 1.5% Yes Yes
MAYTAG CORP $ 4,094 $ 4,324 94.7% 15.5% Yes Yes
MARTIN INDUSTRIES INC/DE $ 21 $ 64 32.8% 0.1% NO Yes
SMITH (A O) CORP $ 349 $ 1,151 30.3% 1.3% NO Yes
NACCO INDUSTRIES -CL A $ 650 $ 2,970 21.9% 2.5% NO Yes
GILLETTE CO $ 1,657 $ 9,295 17.8% 6.3% NO Yes
ILLINOIS TOOL WORKS $ 483 $ 10,404 4.6% 1.8% NO Yes
GENERAL ELECTRIC CO $ 5,806 $ 127,376 4.6% 22.0% NO Yes
BERKSHIRE HATHAWAY -CL A $ 963 $ 27,347 3.5% 3.6% NO Yes
$ 26,427 100%

Copyright © 2002 Ibbotson Associates, Inc. Page 24

Michael W. Barad

IbbotsonAssociates
225 N. Michigan Avenue
Suite 700
Chicago, IL 60601-7676
312-616-1620 Phone
312-616-0404 Fax
mbarad@ibbotson.com
www.ibbotson.com

Copyright © 2002 Ibbotson Associates, Inc. Page 25