The confusion resulting from many finance practices isn’t your fault, says Pablo Fernandez (professor of finance, IESE Business School in Madrid) in a new and highly readable essay. BVWire—UK recommends this analysis to anyone who (sometimes) struggles to explain their conclusions to end-users (or their friends and family).
Many of the topics have to do with the weighted average cost of capital (WACC), which Fernandez points out simply ‘is not actually a cost.’ Others have to do with betas and problems with risk analysis and market or portfolio returns. (One item on Fernandez’s list explains why you shouldn’t sell hair tonic to balding men.)
However, the equity risk premium (also called market risk premium, market premium, equity premium, and risk premium) dominates the confusion. ‘Textbooks, professors, analysts and practitioners differ a lot on their recommendations.’
‘The term “equity premium” is used to designate four different concepts,’ says Fernandez:
- Historical equity premium (HEP): historical differential return of the stock market over treasuries;
- Expected equity premium (EEP): expected differential return of the stock market over treasuries;
- Required equity premium (REP): incremental return of a diversified portfolio (the market) over the risk-free rate required by an investor. It is used for calculating the required return to equity; and
- Implied equity premium (IEP): the required equity premium that arises from assuming that the market price is correct.
‘Although the HEP is equal for all investors, the REP, the EEP and the IEP are different for different investors,’ which adds to the confusion, Fernandez observes. Different values derived from different investor perspectives creates ‘a kind of schizophrenic approach to valuation.’
To make matters worse, ‘textbooks differ a lot on their recommendations regarding the equity premium,’ the professor writes in another analysis called “The Equity Premium in 150 Textbooks,” in which he reviews 150 textbooks on corporate finance and valuation published between 1979 and 2009 by authors such as Brealey, Myers, Copeland, Merton, Ross, Bruner, Bodie, Penman, Arzac, and Damodaran. ‘Their recommendations regarding the equity premium ranged from 3% to 10%,’ he finds. Worse still, 51 of the 150 books use different equity premia in different pages.
Looking to reduce the confusion? For those 150 authors, the average was 6.5%.
Fernandez realizes his list of 18 confusing finance topics is only a start: ‘I already discuss all 18 every semester with my students,’ but, if BVWire—UK readers come up with more, ‘I will do my best to badly explain those as well.’