As central as it is to every decision at the heart of corporate finance, there has never been a consensus on how to estimate the cost of equity and the equity risk premium. Conflicting approaches to calculating risk have led to varying estimates of the equity risk premium from 0 percent to 8 percent—although most practitioners use a narrower range of 3.5 percent to 6 percent. With expected returns from long-term government bonds currently about 5 percent in the US and UK capital markets, the narrower range implies a cost of equity for the typical company of between 8.5 and 11.0 percent. This can change the estimated value of a company by more than 40 percent and has profound implications for financial decision-making. –McKinsey Quarterly, July 2005
Read Chapters 7 and 8 on Calculating Equity Cost in Kenneth Hackel’s:
Here is a synopsis by the Author: http://seekingalpha.com/instablog/680504-mcgrawhillprofessional/107429-interview-with-ken-hackel-author-of-security-valuation-and-risk-analysis
Tell us what your new book is about?
Rarely does a does a book on finance and investments “break important new ground.” I believe Security Valuation and Risk Analysis, encompassing my four decades covering about every facet of security analysis and corporate finance, does so. In it I show that:
- Cost of equity capital, a principal component of stock value, should not be determined by security volatility, as is widely practiced by public enterprises, investors, consultants and security analysts, but by the certainty related to the entity’s cash flows and credit health. A one percentage point change in cost of equity often results in a 25% or greater change to fair value and very often precedes turns in the underlying stock movements;
- Return on Invested Capital (ROIC), a principal component of valuation, should be measured as a function of the assets ability to produce free cash flows, as it should benchmark the expected cash return for cash expended (invested capital, as adjusted). It should not be based on Earnings before depreciation, taxes and depreciation (EBITDA). EBITDA, an income statement based accounting concept, is not a measure of the true economic return;
- Free cash flow should include cash the entity could easily free up, but to be correctly computed, must be adjusted for the many misclassifications and extraordinary items frequently found in reported financial statements. Such adjustment procedures are explained
I prefer books written by practioners rather than academcs.
Learn from anyone and everyone. You’ll be surprised what information you can glean about business from about anyone you might meet. Ask about their job, what (if not nonpublic and material) their company could be doing to become more efficient, what it might be doing wrong or well, as well as the firm’s customers, clients, and competition. While all security analysts like to spend time with the chief financial officer (CFO), in a large organization it’s really the professionals that report to the CFO who carry the valuable information and expertise. For instance, if possible, I like to speak to the individual who wrote particular footnote sections of the 10K or 10Q, such as the manager of global tax or the pension manager.
The chief motivational factor over the course of my professional career has been my desire to learn and experience all there was when it came to analyzing stocks. A good security analyst always should seek out individuals from whom to learn, books to study, and schools and conferences from which to receive training. An analyst must use his or her resources and ask sound questions based on an understanding of the subject or an obvious quest for such an understanding. As a young analyst, I chaired the Education Committee at the New York Society of Security Analysts, so I had access to high-ranking individuals whom I could invite, visit with, and learn from.
An analyst needs to be as inquisitive as a police detective—nd as probing and as suspicious. An analyst never should get complacent during bull markets or be so doubting during bear markets as to lose sight of the long-term opportunities.
The main problem: Assessment of risk
The author says, “I believe that the most glaring weakness in investment and security analysis relates to the assessment of risk—the determination of a proper cost of equity capital.
The analysis of risk represents the single most important underexplored factor in security research and the primary reason for investor disappointment in their investment returns.
The cost of equity capital, while known as a measure of investors’ attitudes toward risk, more aptly should represent the uncertainty to the cash flows investors can expect to receive from their investment in the security being considered. Only through an accurate and reliable cost of equity capital can fair value be established, as well as the determination of whether management is creating value for shareholders, as measured by the return on invested capital (ROIC) in comparison with its cost.
I am gauging risk to the cash flows, just as a debt holder would evaluate the risk of payment of interest and repayment of principal. If the entity is overcapitalized yet has poor or inconsistent free cash flow, its cost of capital could, by my measure, be greater than the average entity. Such an enterprise would benefit from its short-term ability to weather economic events, but unless cash flows improved, it would risk losing that flexibility.”
The book may help you improve your analytical abilities but it is a dense read.
HAVE A GREAT WEEKEND!
3 responses to “Another Way of Calculating Equity Capital Cost/Risk”