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The Risk Premium Factor: A New Model for Understanding the Volatile Forces that Drive Stock Prices

ISBN: 978-1-118-11861-0
224 pages
August 2011
The Risk Premium Factor: A New Model for Understanding the Volatile Forces that Drive Stock Prices (1118118618) cover image


A radical, definitive explanation of the link between loss aversion theory, the equity risk premium and stock price, and how to profit from it

The Risk Premium Factor presents and proves a radical new theory that explains the stock market, offering a quantitative explanation for all the booms, busts, bubbles, and multiple expansions and contractions of the market we have experienced over the past half-century.

Written by Stephen D. Hassett, a corporate development executive, author and specialist in value management, mergers and acquisitions, new venture strategy, development, and execution for high technology, SaaS, web, and mobile businesses, the book convincingly demonstrates that the equity risk premium is proportional to long-term Treasury yields, establishing a connection to loss aversion theory.

  • Explains stock prices from 1960 through the present including the 2008/09 "market meltdown"
  • Shows how the S&P 500 has consistently reverted to values predicted by the model
  • Solves the equity premium puzzle by showing that it is consistent with findings on loss aversion
  • Demonstrates that three factors drive valuation and stock price: earnings, long term growth, and interest rates

Understanding the stock market is simple. By grasping the simplicity, business leaders, corporate decision makers, private equity, venture capital, professional, and individual investors will fully understand the system under which they operate, and find themselves empowered to make better decisions managing their businesses and investment portfolios.

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Table of Contents

List of Figures xi

List of Tables xiii

Preface xv

Evolution of a Theory xvi

Overview xvii

How This Book Is Structured xxi

As You Begin xxii

Acknowledgments xxiii

About the Author xxv

Chapter 1 Understanding the Simplicity of Valuation 1

Rates, Compounding and Time Value 3

Why Time Value Matters for the Stock Market 3

Valuing a Perpetuity 4

Constant Growth Equation: The Key to Understanding the Stock Market 5

Not the First to Try This 6

Why Growth Rate and Cost of Capital Matter 9

P/E Ratio Expansion and Contraction 10

CAPM, Risk Premium and Valuation 11

Equity Risk Premium 11

Impact of Risk Premium on Valuation 13

Chapter Recap 14

PART ONE Exploring the Risk Premium Factor Valuation Model

Chapter 2 The Risk Premium Factor Valuation Model 18

The RPF Model is Simple, but Does it Work? 21

Estimating the Risk Premium Factor (RPF) 24

Potential Causes for Shifts in the RPF 27

Potential Weaknesses in RPF Theory and Methodology 28

Adjusted Risk Free Rate 29

Comparison to the Fed Model 29

Chapter Recap 31

Chapter 3 Solving the Equity Premium Puzzle: The Link to Loss Aversion 33

Loss Aversion 34

Loss Aversion and Corporate Decision Making 34

Attempts to Solve the Equity Premium Puzzle 35

Impact of Inflation on Value 39

Back to Loss Aversion 39

Our Reptilian Brain 40

Chapter Recap 42

Chapter 4 The RPF Model and Major Market Events from 1981 to 2009 43

Efficient Market Hypothesis 44

How the RPF Valuation Model Explains Black Monday 45

2000 "Dot Com" Bubble: RPF Model Suggests Significant Bubble for the S&P 500 47

How the RPF Valuation Model Explains 2008-2009 Meltdown and Recovery 49

Markets Mostly Efficient and Rational, But Prone to Mistakes 52

Chapter Recap 53

PART TWO Applying the Risk Premium Factor Valuation Model

Chapter 5 Application to Market Valuation 57

Beware of Interest Rates 58

Example: Application to the Market in Late September 2009 59

Why the Source of Growth Matters 61

Chapter Recap 63

Chapter 6 Risk Adjusted Real Implied Growth Rate (RIGR) 65

Analyzing Individual Companies with RIGR 66

RIGR Analysis of Apple and Google Pre-Earnings Announcement 71

Chapter Recap 75

Chapter 7 Valuing an Acquisition or Project 77

Brief Introduction to Valuing an Acquisition or Project 78

Translating Your World View into Numbers 79

Setting the Cost of Capital 84

Example: Utility Acquiring a Risky Asset 86

Selecting the Investment Forecast Time Horizon 87

The All Important Terminal Value 89

Chapter Recap 96

Chapter 8 Case Study 1: Valuation of a High-Growth Business 99

Calculating Enterprise Value and Stock Price 107

Scenario Analysis 107

Chapter Recap 108

Chapter 9 Case Study 2: Valuation of a Cyclical Business 109

Chapter Recap 118

Chapter 10 Using the RPF Model to Translate Punditry 119

Read Carefully Then Analyze 119

What Have I Got to Lose? 120

Beware of Oversimplification 122

Confusing Headlines and Misguided Blame 123

Almost Nailed It 124

Graham and Dodd 125

The Wrong Discussion 127

Dumb Money and Bubbles 127

The Right Discussion 128

Chapter Recap 129

Chapter 11 Using the RPF Model for Investment and Business Strategy 131

Estimating Fair Value: How to Identify and Exploit Bubbles 132

Beware of RPF Shifts 137

Investing in Individual Companies 137

Reported Earnings Can Be Misleading 138

How to Apply the RPF Model to Day-to-Day Business Decisions 140

Capital Structure and Risk Impact Cost of Capital 141

Opportunistic Adjustments to Corporate Capital Structure 141

Creating a Sense of Urgency 142

Avoiding Value Destruction 143

Value Creation 145

Key Merger-and-Acquisition Valuation Concepts 147

Inflation Is the Enemy of Value 147

Final Thoughts 147

Appendix A Mobile Apps: The Wave of the Past 149

Appendix B Technology on the Horizon: What if Moore's Law Continues for Another 40 Years? 152

Appendix C A Simple and Powerful Model Suggests the S&P 500 Is Greatly Underpriced 156

Appendix D S&P Index Still Undervalued 160

Appendix E 30 Percent Value Gap in S&P 500 Closed by Rise in Treasury Yields, Price 163

Appendix F Making a Case for Salesforce.com Valuation 165

Glossary 169

Notes 171

About the Companion Website 177

Index 179

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Author Information

STEPHEN D. HASSETT is a corporate development executive with Sage North America, a subsidiary of The Sage Group plc, a leading global supplier of business management software and services. He has published in the Journal of Applied Corporate Finance and is a regular contributing author for the Seeking Alpha investment website. Previously, he was an executive at the Weather Channel, software entrepreneur and consultant with Stern Stewart & Co. He holds an MBA from the Darden School of Business at the University of Virginia.
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