thesediverseinvestorswillacceptastherightcostofequity
in valuing the company.
Estimation Approaches
Therearethreedifferentwaysinwhichwecanestimatethe
costofequityforabusiness.Inthefirst, wederivemodels
thatmeasuretheriskinaninvestmentandconvertthis risk
measureintoanexpectedreturn,whichinturnbecomesthe
costofequityforthatinvestment.Thesecondapproachlooks
atdifferencesinactualreturnsacrossstocksoverlongtime
periods and identifiesthe characteristicsof companies that
best explain the differences in returns. We then use this
relationshiptoforecastexpectedequityreturnsforindividual
companies.Thelastapproachusesobservedmarketpriceson
riskyassetstobackouttherateofreturnthatinvestorsare
willing to accept on these investments.
Risk and Return Models
Whenthehistoryofmoderninvestmenttheoryiswritten,we
willchroniclethata significantportionofthathistory was
spentondevelopingmodelsthattriedtomeasuretheriskin
investmentsand convertthemintoexpectedreturns.Inthis
subsectionweconsiderthestepsusedtoderivethesemodels
and the competing models.
Steps in Developing Risk and Return Models
To demonstratehowriskisviewedin modernfinance, we
presentriskanalysisinthreesteps. First,wedefineriskin
termsofthedistributionofactualreturnsaroundanexpected
return.Second,wedifferentiatebetweenriskthatisspecific