JDV: Do you mean that CAPM does a poor job of determining the total risk of the firm or just the systematic risk?
joemontana Wrote: ------------------------------------------------------- > JDV: > > Do you mean that CAPM does a poor job of > determining the total risk of the firm or just the > systematic risk? CAPM does a crappy job of everything. It’s one freaking number!
Joey - I agree, CAPM has its flaws, many of them, I started this post to hopefully spur some thoughts into alternate methods. CAPM seems to put too much weight onto company specific volatility. Even though that is a risk for investors it shouldnt have so much weight for cost of equity calculations. I was just out walking the Dog, (no not the dow dogs), and came up with this diddy comments and castrations welcome - 1yr + BY(T.E/T.A) + CAPM(L.T.L/T.A.) Here’s my arguement , lets say a firm has 3 times as much L.T.L as equity, than most of the ‘weight’ will go to the CAPM model, which is appropriate because if a firm has lots and lots of debt, i know I’m way down the pecking order for solvency so I want to use the higher premium. If a firm is mostly equity, very little ltl, then I’m less concerned about default so i’ll accept the same risk premium that bond holders would, I know, I know, there’s flaws but lets open this up for discussion…
A few thoughts Why does CAPM put too much weight onto company specific volatility (if anything it is too little because of portolio theory)? A volatile company should have high beta. It definitely have much weight for CoE calculations. If a company has lots of debt it will have a (slightly) higher cost of debt and very high cost of equity. Low levels of debt mean CoE is much lower also. Downside risk is equally important in equity valuation as in bond valuation and upside and expected return is equally important for bond holders. I don’t follow your reasoning. You can’t say that the only cost for a company to issue equity is 1/PE i.e. 4% in your example. The PE is high because profits are expected to be higher in the future and next year you will pay much more (hopefully) to your new equity holders. All calculations of CoE or WACC are flawed, we just need to have acceptable (by investors, clients etc) ways of making an estimate.
I just don’t see why do you relate CAPM with company specific volatility ? CAPM could not care less about firm-specific risk. You can always diversify it away.
CAPM is a convenient way to explain to your boss that what you are doing is “legit”. Some people are deluded here in saying that Beta explains a lot of market returns - there is no evidence in the academic literature to support CAPM. I don’t give a *** about CAPM - it only got me a job, and helps me to keep one - nothing more - nothing less. The danger comes if people do begin to take CAPM seriously and actually make investment decisions based on it *shudder* I’m a fan of the bond yield + premium. But the problem is, I have problems explaining that to my boss - this method seems like you are pulling something out of thin air. Whereas using the CAPM gives it more “credibility” simply because there are fancy acronyms like CAPM and Beta being tossed about… In reality, equity cost of capital is not measurable. I once had a company ask me what their equity cost of capital is - I said approximately 10% and they asked me why and I said it was just a rough and dirty approximation. They say they are not rough and dirty people and finally decided to use 9.5% as their cost. And I wonder how they got their “precise” number… Finally, I would think that the market risk premium has gone up over the last few months - not down… it would be higher than the long term average…
CAPM is absolutely fundamental model. The only problems are the underlying assumptions. There are far from reality. But it’s still a major part of modern finance. I’d compare it to MM theory. Absolutely no connection with reality but you need to understand MM theory first before questioning reality. Besides, you can’t directly reject CAPM. You just cannot find enough evidence to support it. And those expected returns…or market risk premiums…not something you can find with your calculator.
FWIW, here’s an interesting alternative (that uses current market pricing to impute forward-looking volatility): http://harvardbusinessonline.hbsp.harvard.edu/b01/en/common/item_detail.jhtml?id=R0210J Description: In valuing any investment project or corporate acquisition, executives must decide what discount rate to use in their estimates of future cash flows. The traditional approach is to apply the capital asset pricing model (CAPM), which has remained fundamentally unchanged for 40 years. But the formula–in particular, its beta element–has long been a source of frustration. In fact, corporate executives and investment bankers routinely fudge their CAPM estimates, say the authors, because experience and intuition tell them the model produces inappropriate discount rates. CAPM has three main problems: First, beta is a measure of both a stock’s correlation and its volatility; second, beta is based on historical data; and third, CAPM rates don’t take into account the term of the investment. These factors together result in discount rates that defy common sense. As an alternative to CAPM and its beta element, the authors developed a forward-looking approach to calculating a company’s cost of capital–the market-derived capital pricing model (MCPM). It does not incorporate any measure of historical stock-to-market correlation, relying instead on estimates of future volatility derived from the options market. This is helpful given that investor expectations from the options market are built into a company’s current stock price. Using GE as an example, the authors give step-by-step instructions for how to calculate discount rates with MCPM. They also offer evidence from a range of industries to show that MCPM’s discount rates are more realistic–especially from the corporate investor’s perspective–than are CAPM’s.
I used to search function to look around for threads on cost of equity and found this one. Does cost of equity = required rate of return of that particular stock? For an average stock, I believe the expected return is around 6%. This is made up of something like 3.5%-4% CAGR in profits based on a similar level of real GDP growth and 2%-2.5% from dividends and buybacks. This gives an average P/E of 16.7x, which I think isn’t far off the long-term average. You could be a bit more optimistic and opt for a 7% return assumption, but I think that would be your ball park assumption for the market. The riskier the stock, the higher the required rate of return and hence the higher the cost of equity. Does that make sense? So if you believe you are looking at a high risk stock, perhaps you would need a 10% return on that or equivalently you would only pay 10x P/E. To factor in growth here, you could use a long-term average earnings forecast. So for a Chinese growth company, maybe you assume it can earn 3x its current level of earnings once the company matures, hence you would pay 30x P/E for it now but its COE would be 10%. Does this make sense to people? I am trying to get my head around what exactly COE is supposed to represent and why estimates of it vary so wildly.
Cost of Equity does equal Required Return of the stock, unless you are adding in the transaction costs of acquiring new equity, in which case it is a little higher (for the company). CAPM and other asset pricing models basically attempt to figure out what the average investor in the market (more accurately, a weighted average, where weight is proportional to an investor’s AUM) will pay for equity with specific characteristics (market cap size, volatility, valuation, etc.). A company has to make a credible case that it will make that level of return before the average (read “typical”) investor will provide equity capital. Hence the “cost of equity.”
Carson Wrote: ------------------------------------------------------- > The riskier the stock, the higher the required > rate of return and hence the higher the cost of > equity. > > Does that make sense? So if you believe you are > looking at a high risk stock, perhaps you would > need a 10% return on that or equivalently you > would only pay 10x P/E. But how does CAPM measure risk? Through volatility of historical prices. Is this really correct?
CAPM divides risk into risk that comes from general market forces and risk that comes from company specific forces. Only the risk that comes from the market is paid. The other risks average out to zero, so you need more information or a more complex model if you think you can pick the winners out of that kind of risk. If all you know about the market is that it grows on average but fluctuates from period to period, market volatility is not such a bad measure of risk. Ideally you want a measure of downside risk, since investors typically care about making less than expected more than they care about getting more than expected. If you are willing to assume that the returns are symmetrically distributed, standard deviation is a good first approximation. Otherwise you want something like a semivariance, or some kind of correction for skew.
i am not denying the weaknesses of CAPM, but I see more weaknesses in your example. Market return of 12% - what in the hell? any big 4 reviewer will send this analysis back for recycling. 5-7% is what’s used in practice, see studies by Ibbotson Associates/Morningstar publications. A beta of 3.0 - unreal. You gotta do some significance tests on your beta, don’t just take a beta quoted from bloomberg or something. Even without any mean-reversion adjustments, which are theoretically doubtfull (bloomberg multiples the beta by 2/3 and adds 1/3 - wtf?), a beta of 3.0 is crazy-high. What historical period did you use for it? Did you use monthly or weekly or daily returns? What is the benchmark, S&P or something else.
mpnoonan: I think he uses Bond Yield + 3-4% too. There is a reason people as well as a caveat which I will address as well. He uses a lower discount rate because he has already handicapped the investment by using conservative figures initially. On top of that, he understands the business better than most people. For regular folk, this is not an adviseable strategy. He is definitely not using BYERP today. I read somewhere that when bond yields are ridiculously low, he uses a historical bond yield. In that case he uses either 5-6 as a base. Okay now back to taking cough drops. Stupid winter won’t go away.
Mobius Striptease Wrote: ------------------------------------------------------- > 5-7% Agreed. Read a piece from Damodaran that suggested 5-6% as the suggested erp over the next few years.
So is cost of equity and thus WACC totally subjective? I mean the cost of debt is obvious. It is right there on the balance sheet. On the other hand, if you raise finance by issuing shares, the cost of that is not captured on the income statement. For each investor who buys into your issuance, there will be a different required rate of return. Some will be happy with 4%, others might expect 10%. So is the entire concept of cost of equity and thus EVA and residual income models bunkum? In my opinion, the expected return of the sock market over the next 30 years is in excess of 6% per annum. This is because my base case is that company earnings growth plus dividend payments ought to average 6% per annum (see previous post) and the market is currently below its long-run average valuation levels. As the market reverts to mean, we can expect to earn >6%. So if my expected return is now 7% for equities and UST are offering 3.5% for 30 year bonds, does that make my equity risk premium 3.5% for US equities? Does that sound reasonable? Should ERP be extracted back from your expected market return? If Damordaran is suggesting a 5.5% ERP as suitable, does that not imply that he expects the market to return 9% in the long-term? I don’t see how that is justifible given that long-run historic returns are in the 6%-7% range.
The cost of equity is subjective, and different per investor. That is why a DCF model may cause one investor to buy, and another to sell. The question is, who was right? From a corporate finance perspective, the cost of equity is the return that investors *should* require to compensate them for the risk of your business. In the CAPM this is measured as it’s degree of market risk, because business risk is assumed to be diversified away. Market risk is measured by the correlation between the share’s return and the market return. A consequence of this is that the CAPM provides a meaningless measure of risk if the share is not held in a fully diversified portfolio.
A single number is no an adequate measure of risk under any circumstances. Let me settle this debate by saying that a general range is more appropriate. Stress test your assumptions until it no longer is profitable and then ask yourself - well is this number reasonable? Try to blow up your idea in any way imaginable. If it still survives then it’s a good investment.
Right. After reading and thinking about this yesterday and today, I’ve decided that cost of equity is ballpark 6%-8% and ERP 3.5%-5.5% depending on cirsumstance. Thanks for your input everyone who responded.
Here is my question regarding CAPM, which is causing me confusion. In a bad economy, the CAPM produces a much lower cost of equity and higher valuation, where a good economy produces a much higher cost of equity and lower valuation. Let’s look at a Large Cap stock that has a beta of 1.0. It just seems to move with the market at all times. Good economy - people move their money out of treasuries and into more risky stock investments…low but stable inflation, government occasionally raises interest rates to keep inflation stable less demand for treasuries, prices fall, yields are higher, lets call RFR 5.0% DOW is cooking, everybody is getting 10% returns on their investments, so we say the Expected Market Return is 10%. According to CAPM Ke = RFR + B*(E® - RFR) = 5.0 + 1.0*(10-5) = 10% Bad economy - people move their money into treasuries, out of stocks, government is dropping interest rates, flight to quality, treasuries yielding 3.0% DOW is rough and risky, people aren’t getting high stock returns, lets say the expected return of the market drops to 5%. Ke = 3.0 + 1.0*(5-3)= 5% According to the CAPM, in a better economy, the required return on equity is higher because of the high opportunity costs of capital. This lowers company valuations and wealth is destroyed. Bad economy, lower opportunity cost, required return on equity is alot worse, company valuations will be alot higher and wealth is created…what am i missing? A side note, I calculated a WACC for both situations too, using higher debt rates in a bad economy, and a less leveraged capital structure, as well as raising Beta, and I still get the same result.