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


"Stephen Hassett is onto something. His notion that the risk premium on stocks is not constant, but varies with the risk free rate, helps to explain an enduring puzzle: why actual stock prices vary from the estimates that analysts' models imply. This book will offer fresh and provocative insight to careful students of the stock market. Read it and grow wiser."—Robert F. Bruner, Dean and Charles C. Abbott Professor of Business Administration, Darden Graduate School of Business, University of Virginia

"The equity risk premium is a key input to the cost of capital. During periods of economic stability, practitioners typically used an estimate of the long-term average equity risk premium, typically adjusting the estimate once a year. But all that changed as the crisis in late 2008 unfolded. In these uncertain economic times, we have found the Risk Premium Factor Valuation Model to be a powerful tool for adjusting our equity risk premium estimate as we move through the rapidly changing business cycle. We recommend that practitioners use the Risk Premium Factor Valuation Model to better understand the economic interrelationships that drive the pricing of the broad stock market and the equity risk premium."—Roger J. Grabowski, Managing Director, Duff & Phelps LLC and coauthor of Cost of Capital: Applications and Examples

"Understanding and accurately estimating the cost of capital is fundamental to making decisions that create value. Stephen Hassett's Risk Premium Factor Valuation Model provides an easy-to-understand approach to estimating the cost of equity capital that is accessible and insightful to those with a basic understanding of finance and expert practitioners alike. Further, it demystifies the drivers of market valuation and provides a compelling and often under-appreciated linkage between growth and stock price. It will enrich the perspective of any investor or manager."—David M. Kostel, Managing Director and Co-Head of Healthcare Mergers & Acquisitions, Credit Suisse

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.

List of Figures.

List of Tables.


Evolution of a Theory.


How This Book Is Structured.

As You Begin.


About the Author.

Chapter 1: Understanding the Simplicity of Valuation.

Rates, Compounding and Time Value.

Why Time Value Matters for the Stock Market.

Valuing a Perpetuity.

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

Not the First to Try This.

Why Growth Rate and Cost of Capital Matter.

P/E Ratio Expansion and Contraction.

CAPM, Risk Premium and Valuation.

Equity Risk Premium.

Impact of Risk Premium on Valuation.

Chapter Recap.

Part I: Exploring the Risk Premium Factor Valuation Model.

Chapter 2: The Risk Premium Factor Valuation Model.

The RPF Model is Simple, but Does it Work?

Estimating the Risk Premium Factor (RPF).

Potential Causes for Shifts in the Risk Premium Factor.

Potential Weaknesses in RPF Theory and Methodology.

Adjusted Risk Free Rate.

Comparison to the Fed Model.

Chapter Recap.

Chapter 3: Solving the Equity Premium Puzzle.

The Link to Loss Aversion.

Loss Aversion.

Loss Aversion and Corporate Decision Making.

Attempts to Solve the Equity Premium Puzzle.

Impact of Inflation on Value.

Back to Loss Aversion.

Our Reptilian Brain.

Chapter Recap.

Chapter 4: The RPF Model and Major Market Events from 1981-2009.

Efficient Market Hypothesis.

How the RPF Valuation Model Explains Black Monday.

2000 “Dot Com” Bubble: RPF Model Suggests Significant Bubble for the S&P 500.

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

Markets Mostly Efficient and Rational, But Prone to Mistakes.

Chapter Recap.

Part II: Applying the Risk Premium Factor Valuation Model.

Chapter 5: Application to Market Valuation.

Beware of Interest Rates.

Example: Application to the Market in Late September 2009.

Why the Source of Growth Matters.

Chapter Recap.

Chapter 6: Risk Adjusted Real Implied Growth Rate (RIGR).

Analyzing Individual Companies with RIGR.

RIGR Analysis of Apple and Google Pre-Earnings Announcement.

Chapter Recap.

Chapter 7: Valuing an Acquisition or Project.

Brief Introduction to Valuing an Acquisition or Project.

Translating Your World View into Numbers.

Setting the Cost of Capital.

Example: Utility Acquiring a Risky Asset.

Selecting the Investment Forecast Time Horizon.

The All Important Terminal Value.

Chapter Recap.

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

Calculating Enterprise Value and Stock Price.

Scenario Analysis.

Chapter Recap.

Chapter 9: Case Study #2 - Valuation of a Cyclical Business.

Chapter Recap.

Chapter 10: Using the RPF Model to Translate Punditry.

The varied voices of columnists, writers and sources in financial media are often confusing. This chapter summarizes a selection of recent articles from the financial press and analyzes them through the lens of the RPF Model.

Read Carefully Then Analyze.

What Have I Got to Lose?

Beware of Oversimplification.

Confusing Headlines and Misguided Blame.

Almost Nailed It.

Graham and Dodd.

The Wrong Discussion.

Dumb Money and Bubbles.

The Right Discussion.

Chapter Recap.

Chapter 11: Using the RPF Model for Investment and Business Strategy.

Estimating Fair Value: How to Identify and Exploit Bubbles.

Beware of RPF Shifts.

Investing in Individual Companies.

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

Capital Structure and Risk Impact Cost of Capital.

Opportunistic Adjustments to Corporate Capital Structure.

Creating a Sense of Urgency.

Avoiding Value Destruction.

Value Creation.

Key M&A Valuation Concepts.

Inflation is the Enemy of Value.

Final Thoughts.

Appendix A: Mobile Apps: The Wave of the Past.

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



About the Companion Website.