Problem

Using Past Information to Estimate Required Returns

In the Capital Asset Pricing Model (CAPM) discussion, beta is identified as the correct measure of risk for diversified shareholders. Recall that beta measures the extent to which the returns of a given stock move with the stock market. When using the CAPM to estimate required returns, we would ideally like to know how the stock will move with the market in the future, but because we dont have a crystal ball we generally use historical data to estimate this relationship.

As noted in the chapter, beta can be estimated by regressing the individual stocks returns against the returns of the overall market. As an alternative to running our own regressions, we can instead rely on reported betas from a variety of sources. These published sources make it easy to obtain beta estimates for most large publicly traded corporations. However, a word of caution is in order. Beta estimates can often be quite sensitive to the time period in which the data are estimated, the market index used, and the frequency of the data used. Therefore, it is not uncommon to find a wide range of beta estimates among the various published sources. Indeed, Thomson ONE reports multiple beta estimates. These multiple estimates reflect the fact that Thomson ONE puts together data from a variety of different sources.

Begin by taking a look at the historical performance of the overall stock market. If you want to see, for example, the performance of the S&P 500, select INDICES and enter S&PCOMP. Click on PERFORMANCE and you will immediately see a quick summary of the markets performance in recent months and years. How has the market performed over the past year? The past 3 years? The past 5 years? The past 10 years?