Portfolio Management
Risk of the firm
Referring to the regression results, we found out that the beta of the firm is 0.70. This indicates that the return of the company’s stock are less sensitive from the market that carries a bet multiple of 1. In other words, if the market return changes by 1%, the stock return being less related to that of market return will only change by 0.70%.
In addition, the regression results also provide us with R-Square multiple of 0.32. Important to note, R-Square multiple is the ratio of market risk to the total risk of the firm. In other words, with R-Square multiple of 32%, the firm has a higher proportion of unsystematic risk included in the stock. This means that the major risk in the stock is diversifiable.
Return calculated using Regression Work
Expected Return= Risk free Rate+ Beta(Market Return-RFR)
= 3.83+ .70(1.54-3.83)
= 2.22%
*Market Return= Average S&P 500 Return
*RFR= Average 1 Month Constant Maturity Rates of Treasury
*Beta was used from the regression table
Return calculated using market premium since 1990
Expected Return= Risk free Rate+ Beta(Market Return-RFR)
= 3.83+ 0.70(7.6)
= 9.15%
Conclusion
Comparing the returns, we find that there is huge difference between expected return calculated using the regression results than the market premium since 1990. However, still we would rate later the more reliable measure as it includes data for a higher period of time.
Comparing CAPM Return and Return using Gordon growth Model
CAPM model is the celebrated model used in the financial industry for calculating the expected return of the stock. The calculation includes, risk free rate, beta multiple and the expected market return using the following formula:
Expected Return= Risk free Rate+ Beta(Market Return-RFR)
On the other hand, Gordon Growth Model is a dividend discount model that assumes the growth of dividends in the company will be constant. Here also, the return on equity can be calculated, however, the model involves great assumptions relating to dividend growth which is likely to vary from individual to individual.
Hence, CAPM model is much more fundamental and accurate than Gordon Growth model for calculating returns.
