Re: Cost of equity
Evan,
I think we agree on most everything, but I'm confused about this post.
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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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It's not obvious that the required cost of equity is unobservable? What kind of situation are you talking about? What kind of observable measures of costs of equity are you thinking about? I still think it's pretty obvious that costs of equity are completely unobservable, short of taking a poll of investors (and even then you're in the world of distinguishing between stated preferences and revealed preferences).
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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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I don't know what this refers to - I don't think I mentioned the S&P 500.
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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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I believe you need a premium for holding an individual security rather than an index (talking about your only holding here, not talking about a basket of individual securities) because you need to be compensated for the total risk, both systematic and unsystematic, whereas you can diversify away part of that risk by buying an index. I'm not sure what you're arguing here. Is it possible that a firm's total risk will be less than an index's total risk? Obviously, if the firm has a beta of less than 1, it's theoretically possible, but it doesn't seem very likely for a normal, publically-traded operating firm (as opposed to a firm that just owns some treasury notes).
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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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Yeah, I have no idea what you're talking about here. I'm not making any assumptions about efficient markets. Empirically, the IRR that equates future cash flows to the current stock price is the firm's current cost of equity. Are you saying that if the stock prices drops by 50% without a corresponding drop in the expected future cash flows, the firm doesn't face a higher cost of equity than they did prior to the stock price?
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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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Sorry, I meant to say different but similar firms. I don't at all believe that all firms' cost of equity should be the same.
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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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This is the crux of the matter, right? Because costs of equity are ultimately unobservable (I'm still interested in why you think otherwise), there isn't a validation that you can do. What would you use to determine whether one method is better than another at arriving at a cost of equity? The whole discussion/problem comes about because there's no agreed-upon way of doing it. There's not even any after-the-fact verification because ex ante estimates do not translate directly to ex post results.
I'm surprised you had so much disagreement with what I wrote, considering I agree with most of what you're saying. Just not the observability of costs of equity.
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