a quick question - how to value a company using CAPM to caculate cost of equity of a bad market. Take China's Shanghai stock market as an example, the index decreased from 6,000 in 2007, to 3,000 in 2010, to 1,990 in 2012. we could not use a negative risk premium, right?
thanks!
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Unlike beta, the market risk premium is found using very long time spans. If you have data for the past 50-60 years, then use that.
my teachers told my just use a fixed 7%~8% as MRP as researchers would use. But I have no idea when in such a crazy market, this discount rate really makes senses?
Correct. The only problem right now is the historical MRP of ~4.5-5.5% over the current 10 year Treasury of 1.60% yields an unrealistically low Cost of Equity and therefore WACC making your DCF or whatever model inaccurate.
How do you correct for this in the current market environment?
According to Ibbotson, the long-term market risk premium is 6.6%. Risk free return is 1.7%. Your cost of equity will be some component of the MRP and Beta. You can also have a micro-cap size premium that will jack-up the Cost of Equity for Micro-cap companies that are not as liquid and and a little more risky.
Just because the market dips tomorrow does not change the market risk premium that much. The risk free rate will certainly change the cost of equity and that is correlated with the general market (if the market crashes then the risk free rate falls with a flight to safety).
If you don't have data for a longer period of time, or if data is messed up due to the recent bust, you can just use a MRP within the "normal" range, i.e ~6-8%.
Note that CAPM doesn't price volatility per se; it prices volatility for a single company (or asset) relative to the market. If volatility has been very high recently, this might feed into the MRP, but this is very difficult to estimate so using historical rates is probably your best option.
Much appreciated. Really helps!
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