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#1
11-26-2005, 07:27 PM
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Cost of equity
In the EVA thread the OP wrote this, "a cost of equity calculation does not require beta, it’s just something that’s historically been used a lot." I thought it was an interesting statement because it's something I haven't thought about a lot.
Cost of equtiy has always evoked the thought of "risk free rate plus beta times the risk premium" for me. Thinking about it there obviously SHOULD be other ways to go about it, but I can't think of any. I'll put some more effort into this later because I feel like I should be able to come up with something reasonable, but I wanted to post it before I forgot. So, how would you calculate a cost of equity without using a beta? I'd like to stay away from dividend models due to popularity of not paying divdends these days. 
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#2
11-26-2005, 08:02 PM
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Re: Cost of equity
WACC
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#5
11-28-2005, 01:48 PM
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Re: Cost of equity
[ QUOTE ]
WACC is Weighted Average Cost of Capital. [/ QUOTE ] I know. That's not an answer to my question [ QUOTE ] Also, cost of equity is very theoretical and seldomly used in the real world. What are you trying to accomplish? [/ QUOTE ] Nothing really, other than satisfying curiosoty. What's the difference?
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#6
11-28-2005, 01:59 PM
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Re: Cost of equity
WACC = only thing i remember from finance class..lol
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#7
11-28-2005, 02:42 PM
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Re: Cost of equity
[ QUOTE ]
WACC = only thing i remember from finance class [/ QUOTE ] Remember that WACC uses Ke as one of its inputs, so it can't possibly be an answer to 'how to calculate Ke w/o beta?' PS Last week I reviewed a securities analysis assignment for a friend of mine attending Georgetown. To value Colgate, they used a beta of 0.16 (????), giving them a Ke of around 5.6%, which (when combined with their outrageous EPS growth assumptions) gave an intrinsic value for CL of around $400 per share. Awesome.
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#8
11-28-2005, 02:49 PM
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Re: Cost of equity
Charlie Munger made a comment in a recent annual meeting (2003?) that was something like, "At it's core, economics all boils down to opportunity cost." That's what I think about when I think about cost of equity.
The cost of equity is going to be the rate of return that investors require from holding a particular equity instrument. That's unobservable, obviously. What you can do is look at economically similar instruments to get an idea for what that number should be. Beta is a historically popular number (obviously not popular with Berkshire Hathaway). The most common beta calculation comes from a regression of firm excess returns on market excess returns. The assumption is that there is a common market risk factor and you should earn the risk premium to the extent that the individual stock shares that risk factor. But academics define lots of different betas, rather than the market beta. A beta is basically just the exposure of a firm to any particular risk factor. In the CAPM case, the singular beta is the exposure to the market factor. You can open that up to multifactor models, where each beta represents exposure to a particular risk factor. (The Fama-French three factor model, perhaps). So maybe you're not satisfied with betas. You could say, "Screw the math, I just want to figure out my cost of equity." Here are some starting thoughts: 1. It must be higher than the risk-free rate 2. It must be higher than any available instrument with less risk (however you define that) 3. It should be equal to your required equity rate for instruments with similar risk So you might start by saying, "I need the historical market's rate of return." But that's not exactly true because what you really need is the historical market premium plus the current risk-free rate. But that's not necessarily true because you can invest in an index fund (that many people would describe as less risky) and get that rate. So you need the current real risk free rate, plus expected inflation, plus the risk premium, plus some premium for holding an individual stock rather than an index. How do you do it? I don't know - it's obviously messy. Using the math-oriented beta is just one way. Maybe you just know that you need at least a 10% return when you invest in something - that's your hurdle rate and therefore your cost of equity. The best estimate you can get for a firm's cost of equity (in my view) is to look at the implied cost of equity in the current share price. Make your best estimate of future free cash flows (or dividends, if available) and figure out the IRR that sets the present value of those cash flows equal to the current stock price. Do that for a number of different firms and maybe that's the current equity cost of capital. It's an unsatisfactory answer, right? There's no good way to calculate the cost of equity in a rigorous fashion, other than saying it's the opportunity cost across all possible investment opportunities with the same degree of risk. Which, by the way, comes back to provide some support for the historical beta. Usually when I'm talking to someone about beta, they hate it - just like you do. They usually hate it a little less when I say the following: When you're buying a stock, imagine that you're only choosing to buy the entire market index or that stock. You can't compare the cost of equity for the entire index to the cost of equity for the individual stock - the index is less risky. But you can adjust for this! If you want to buy the index in such a way to equal the risk inherent in an individual stock, you can lever up or lever down the amount purchased. You can roughly match the risk of a levered index position to the risk of an individual stock by levering up or down until the volatility of the levered position is equal to the volatility of the stock position. Therefore, you should require a return on the individual stock equal to at least the levered return of the index. What's that? Beta is the amount of the leverage, so your required return is beta times the market's excess return. If you can't get at least that from investing in the individual stock, you're better off investing in the levered market position. I don't know if that's satisfying to you, but it makes me think there's at least some value in beta even though I don't buy into it completely.
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#9
11-28-2005, 04:51 PM
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Re: Cost of equity
[ QUOTE ]
The cost of equity is going to be the rate of return that investors require from holding a particular equity instrument. That's unobservable, obviously. [/ QUOTE ] I think you might be stretching a bit here. This may be true, but I don't think you can say it's obvious. [ QUOTE ] In the CAPM case, the singular beta is the exposure to the market factor. [/ QUOTE ] You can always deefine "the market" in a different way if you want. It doesn't have to be hte S&P 500. [ QUOTE ] So maybe you're not satisfied with betas. You could say, "Screw the math, I just want to figure out my cost of equity." Here are some starting thoughts: 1. It must be higher than the risk-free rate 2. It must be higher than any available instrument with less risk (however you define that) 3. It should be equal to your required equity rate for instruments with similar risk [/ QUOTE ] Points 2 and 3 are sort of repetative and essentially restatements of the security market line. [ QUOTE ] what you really need is the historical market premium plus the current risk-free rate. But that's not necessarily true because you can invest in an index fund (that many people would describe as less risky) and get that rate. So you need the current real risk free rate, plus expected inflation, plus the risk premium, plus some premium for holding an individual stock rather than an index. [/ QUOTE ] Why do you need a premium for holding an individual stock? Obviously if the stock is riskier than the market as a whole you need a premium for that, but it's got nothing to do with the number of securities. You don't get rewarded for systematic risk beyond the market risk premium. Determining the cost of equity is basically an exercise in evaluating unsystematic risk. [ QUOTE ] The best estimate you can get for a firm's cost of equity (in my view) is to look at the implied cost of equity in the current share price. [/ QUOTE ] Woah. You're implying a lot of assumptions about efficient markets in that statement. [ QUOTE ] Do that for a number of different firms and maybe that's the current equity cost of capital. [/ QUOTE ] Are you saying that all firms' cost of equity should be the same? [ QUOTE ] There's no good way to calculate the cost of equity in a rigorous fashion, other than saying it's the opportunity cost across all possible investment opportunities with the same degree of risk. [/ QUOTE ] Fair enough, what is another way that is AS GOOD AS a historical levered beta or a built up beta? [ QUOTE ] Which, by the way, comes back to provide some support for the historical beta. [/ QUOTE ] I think a bult up beta is much more "reliable" than a historical beta. [ QUOTE ] Usually when I'm talking to someone about beta, they hate it - just like you do. [/ QUOTE ] I don't really hate it. And to some extent I even like built up betas in that I think they're reasonable ways to estimate the opportunity cost we're looking for. I just think it would be interesting to find other ways of doing it. [ QUOTE ] You can't compare the cost of equity for the entire index to the cost of equity for the individual stock - the index is less risky. [/ QUOTE ] This is wrong. There is no way "the index" is always less risky than an individual stock.
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#10
11-28-2005, 05:23 PM
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Re: Cost of equity
[ QUOTE ]
So, how would you calculate a cost of equity without using a beta? [/ QUOTE ] I'm assuming from your post that you're referring to a single measure of beta used in the CAPM. Actually some equity is notorious for being highly risky but low beta. Gold stocks in particular come to mind. MREITs are another example IMO. I think FatOtt alluded to an arbitrage pricing model where several risk factors are weighted to determine the cost of equity. So.......... it depends on the firm in question. Something like PG, GE, MSFT the CAPM becomes a decent way to arrive at the cost of equity. Other firms that are dependent on the value of a single commodity or highly interest rate sensitive, perhpas a different pricing model is better. Gold stocks and MREITs have relatively low R-Squared values so I would opine that in evaluating whether or not the cost of equity should be determined by the CAPM, one should look at the R-Squared.
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