Re: Cost of equity
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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.
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I think you might be stretching a bit here. This may be true, but I don't think you can say it's obvious.
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In the CAPM case, the singular beta is the exposure to the market factor.
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You can always deefine "the market" in a different way if you want. It doesn't have to be hte S&P 500.
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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
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Points 2 and 3 are sort of repetative and essentially restatements of the security market line.
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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.
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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.
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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.
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Woah. You're implying a lot of assumptions about efficient markets in that statement.
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Do that for a number of different firms and maybe that's the current equity cost of capital.
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Are you saying that all firms' cost of equity should be the same?
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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.
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Fair enough, what is another way that is AS GOOD AS a historical levered beta or a built up beta?
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Which, by the way, comes back to provide some support for the historical beta.
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I think a bult up beta is much more "reliable" than a historical beta.
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Usually when I'm talking to someone about beta, they hate it - just like you do.
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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.
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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.
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This is wrong. There is no way "the index" is always less risky than an individual stock.
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