Estimating the Required Return In a World of Heightened Uncertainty: Emphasizing the Equity Risk Premium

Heightened uncertainty over the past five years--due to the bursting of the NASDAQ bubble, the recession of 2001, the September 11th attacks, accounting scandals, and the oil shocks of 2005--has brought new challenges for securities analysts and portfolio managers. This observation is particularly relevant for fundamental equity managers using price relative and/or discounted cash flow (DCF) models. While correctly worrying about values of cash flow input (dividends, free cash flow, economic earnings) to DCF models, portfolio managers must be especially aware of risk factors that impact the required return or discount rate, and relatedly, market valuation multiples. This discount rate concern is evident in the stock prices of several large cap, “blue-chip” companies (for examples, Coca-Cola, General Electric, Pfizer, and Wal-Mart), whose stock market performance in recent years has been flat, despite a wide variation in interest rates over the December 1999 to March 2005 period and profits and cash flows rising