Cost of equity

[Sniper]

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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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In general, the risk in owning an index is less than the risk of holding a single stock, due to diversification reducing the overall risk!

That said, some indexes are overdiversified, and you can achieve similar diversification risk reduction by holding a few select stocks.

[Evan]

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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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In general, the risk in owning an index is less than the risk of holding a single stock, due to diversification reducing the overall risk!

That said, some indexes are overdiversified, and you can achieve similar diversification risk reduction by holding a few select stocks.

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Okay, in general it may be true, but not often enough to make the blanket statement that indices are less risky than stocks.

The beta of a market is 1, it is not true that no stock's beta is <1.

[adios]

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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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In general, the risk in owning an index is less than the risk of holding a single stock, due to diversification reducing the overall risk!

That said, some indexes are overdiversified, and you can achieve similar diversification risk reduction by holding a few select stocks.

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Okay, in general it may be true, but not often enough to make the blanket statement that indices are less risky than stocks.

The beta of a market is 1, it is not true that no stock's beta is <1.

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I made post awhile back about evaluating the risk in investing all of ones money in a particular stock. FatOtt and I had a good exchange of views on what I wrote. I know you know this already but for others that may be following along in this thread, since individual company risk can be "diversified away," there is no risk premium for assuming individual company risk. To use my MREITs and Gold stocks example again, these stocks generally speaking have low betas but there is no way in the world that these stocks are lower risk than something like SPY. This is due to the fact that these stocks have low R-Squared values which mean that they're not highly correlated to the overall market and thus the beta's are a poor measure of risk.

[Evan]

You already kind of said this, but I'll reitterate it; beta is not a metric of risk in the sense most people might think. It measures unsystematic risk that cannot be diversified away. Those are NOT the same thing. Companies with low betas being risky isn't really the oxymoron many people think it is.

[FatOtt]

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.

[Evan]

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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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I guess I took "observable" to mean something more along the lines of "attainable". Even still, I think there's a case for a regression beta to be an observable cost of equity.

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I don't think I mentioned the S&P 500.

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You didn't. The point was that if you don't feel that "the market" reflects a good benchmark for a stock you don't have to use the standard. I wasn't really correcting you, just expanding on your point.

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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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You don't get rewarded for diversifiable risk because you can diversify it away. Therefore your cost of equity does not increase due to diversifiable risk.

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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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Basically you're assuming that all sotcks are fairly valued at the moment, right? That assumes that markets are efficient. You have two inputs (discount rates, cash flows) and one output (value). You have to start with two known variable to calculate the third. If you start with cash flows and value as givens then you're assuming the stock is fairly valued in order to find the true discount rates. If you assume that all stocks are always fairly valued then you assume markets are efficient.

To asnwer your last question, no, the lower stock price does not necessarily mean the cost of equity is higher.

[FatOtt]

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Even still, I think there's a case for a regression beta to be an observable cost of equity.


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Regression betas over many, many firms over long periods of time might give you average betas that are unbiased. That assumes a rational expectations environment where, on average, investors' expectations of future returns are true. That's a fairly strong assumption - even for a guy living in Famaland, Chicago, like I do.

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You don't get rewarded for diversifiable risk because you can diversify it away. Therefore your cost of equity does not increase due to diversifiable risk.

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Edited to say that I have potentially screwed up the issue and it's probably lead to confusion. There are two things going on: What I require for holding a stock and what the market will give me. If I were to hold only one individual stock in my portfolio, I would require an expected return greater than I would require for holding the index. The market will not give me that return because, by diversifying, they can reduce the risk. I'm talking about what I would require for an individual stock return whereas you seem to be jumping the gun to point out that the market would not give me that return (a point that I agree with). If we look at it from the perspective of the firm, if the market doesn't reward the investor for holding diversifiable risk, the firm's cost of equity shouldn't reflect that. At this point, I can't remember if we're talking about:
- ways that an investor would calculate his required rate of return, or
- ways that a firm would calculate its cost of equity

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Basically you're assuming that all sotcks are fairly valued at the moment, right? That assumes that markets are efficient. You have two inputs (discount rates, cash flows) and one output (value). You have to start with two known variable to calculate the third. If you start with cash flows and value as givens then you're assuming the stock is fairly valued in order to find the true discount rates. If you assume that all stocks are always fairly valued then you assume markets are efficient.

To asnwer your last question, no, the lower stock price does not necessarily mean the cost of equity is higher.

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No - I am assuming that all stocks are valued, period. If the market irrationally prices a firm's shares so that the price is 10% of the "Buffettesque Intrinsic Value", that firm does face a higher cost of equity. Why? Because when they go to issue shares, they have to issue shares into the environment that is underpricing the equity. By issuing shares when the stock is extremely undervalued, the firm is incurring a very high cost of equity.

It's easier to see in the case of debt because the debt rates are observable. If the firm issues a bond into an environment that prices the bond at par value, the (marginal) cost of debt will be equal to the coupon rate of that bond. If the market values that debt at 20% of par, the cost of debt is much higher - that's true regardless of whether the 80% haircut was rational or not.

By the way, have you ever been to a Berkshire Hathaway annual meeting? If not, you should go - it's a good time. You should also get a group of students (I think you're in school) to go visit Buffett in Omaha.

[Evan]

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Regression betas over many, many firms over long periods of time might give you average betas that are unbiased. That assumes a rational expectations environment where, on average, investors' expectations of future returns are true. That's a fairly strong assumption - even for a guy living in Famaland, Chicago, like I do.

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This is pretty much what a built up beta is.

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What I require for holding a stock and what the market will give me. If I were to hold only one individual stock in my portfolio, I would require an expected return greater than I would require for holding the index.

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Okay, but you wouldn't just be holding the one tock and you COULD diversify. The "true" cost of equity for that firm should assume diversification is possible. The one stock portfolio was just an example used to demonstrate what a cost of equity is, not a real life scenario.



I don't think your cost of debt analogy is correct. Cost of debt is an explicit rate (although not when there is no recently traded or issued debt) while cost of equity is largely implicit. The price:rate ratio doesn't really hold or equity. It doesn't really hold for debt either, which is why people often turn to things like interest coverage ratios to impute accurate discount rates for debt when no recent transactions are available. The quoted interest rates on debt can be VERY different from what the firm would have to pay if it were to issue debt in the present.

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By the way, have you ever been to a Berkshire Hathaway annual meeting? If not, you should go - it's a good time. You should also get a group of students (I think you're in school) to go visit Buffett in Omaha.

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Never been. You have to own a share to attend, correct? I've thought about buying a class B share just to go to the meeting, but I haven't done it yet. I am in school at NYU, so the group idea is a good one.

[buffett]

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By the way, have you ever been to a Berkshire Hathaway annual meeting? If not, you should go - it's a good time. You should also get a group of students (I think you're in school) to go visit Buffett in Omaha.

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Are you one of the people behind The Buffett Blog??? Were you part of the most recent group of Chicago kids that went to Omaha and did the Borsheims/NFM/BRK tour?

Evan, I totally agree....you need to organize a group of NYUers and take them to Omaha. (Plus, you also need to attend the BRK AGM at least once while they're both still alive. Forget about the fact that WEB has already said everything's he's going to say and you're not going to learn anything....go for the experience and the camaraderie.) I went in October 2003, and it was easily the highlight of my two years of school.

[Sniper]

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Okay, in general it may be true, but not often enough to make the blanket statement that indices are less risky than stocks.

The beta of a market is 1, it is not true that no stock's beta is <1.

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In the way that you used it, Beta represents correlation to the market.

Thus, while it can be used to measure the level of market risk; it can not be used to measure individual stock risk.

I suggest you spend some time on riskgrades