Markets and the Price of Risk

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What is the price of risk? Not very much it seems as I sit here writing this on the 13th of July. The pandemic refuses to relent but someone hasn’t told this to Mr. Market. Nifty is soaring upwards of 10,800. The bulls and the bears are locking horns again.

What is the price of Risk? The answer is pretty clear in the bond markets. It’s the default and the illiquidity spread added to the risk free spread. And yet we have no mechanism for this in equity markets. Let me correct that, we do have one but it’s not very popular. The implied equity risk premium measures how equity markets are pricing risk. What is it? How is it calculated? In this post I explain what it is and why it’s more relevant today than ever.

Nifty: FCFE

Free cash flow to equity is the cash that flows to equity investors after reinvesting in capital expenditure, non-cash working capital and net debt payments. It is the cash used to buy back stocks /pay dividends or keep as cash for further use. I used the latest available numbers to calculate the free cash flow to equity for all nifty stocks. Share buybacks aren’t common in India hence I used the latest dividend payout plus net change in cash to calculate the free cash flow to equity. I added the net change in cash because we know that companies don’t payout in dividends everything that they can. The details are shown below:

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Sheet 1 (Source Tickertape)

Discounted Cash Flow Valuation

I use this model to value the entire market. The basic principle being that the value of nifty should be the all the free cash flows to equity in subsequent years discounted back at the cost of equity. Now any discussion of the market right now is futile without taking into account the current pandemic. Hence I identified two cases:

Case 1: What these numbers tell us pre Covid 19

Case 2: What these numbers tell us post Covid 19

Pre Covid 19

Here I try to neglect hard as it may be the effect of Covid 19. Please refer to sheet 2 for reference. The free cash flow to equity is about 3.43% of the nifty. Assumptions:

· Growth Rate: I assume a growth rate of 11.45%. This is was the growth rate for previous 5 years and with no Covid this shouldn’t change

· Risk Free Rate: The risk free rate is taken as the 10 year government bond rate adjusted for the default spread. Since at this time India’s rating wasn’t downgraded yet the risk free rate comes out to about 5%

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· Cost of Equity: Using the capital asset pricing model the cost of equity for the market is the risk free rate plus the equity risk premium. (beta=1) The equity risk premium for India is basically the mature market Equity Risk premium plus the country risk. I used the numbers from Aswath Damodaran’s official site to compute this

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Sheet 2

I input all the values and get a value for the nifty at 9156. I then inverted the calculation and calculated the cost of equity to arrive at the current price of nifty 10802.7. This gives me my implied cost of equity and that comes out to be 10.91%. In turn I compute my implied equity risk premium at 5.84%. This put against the 6.79% (in the image) shows that we weren’t pricing enough risk for equity even if things were all good. Now for the second case

Post Covid 19:

My assumptions have now changed:

· Growth Rates: I assumed no growth for 2 years and then the same growth of 11.45% post that as things return to normal. Given the current GDP estimates this might seem to be a tad optimistic but the market seems to be an optimistic mood.

· Risk Free Rate: Now we have to factor in the effect of the recent credit rating downgrade. Given the current 10 year yield at 5.786% the risk free rate comes out to be 2.97%. (Refer to sheet 3)

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· Cost of Equity: The direct impact of the corona virus has been mature markets are pricing in more risk. Adding to this the country risk premium I get the equity risk premium at 8.5%

I computed for the assumptions given above and got the value of nifty at 6623. The implied cost of equity and the implied equity risk premium comes out to be 8.06% & 5.69% respectively. In this case the implied equity risk premium is the same as that of more mature markets. In fact the implied cost of equity is marginally lower than many corporate bond yields. It is even lower than bonds of many Public Sector Units.

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Sheet 3

Conclusion:

Is there a bubble? There might or might not be. Let’s flip the question though. If you are a company right now would you raise money through debt or cash?



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Himanshu Sinha
Himanshu is hugely into Value Investing, Complex Adaptive Systems, Business Analysis, Behavioral Finance, and Spotting Market inefficiency.
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