Awww, it’s a little value investor in the making
Interesting diesel. I hadn’t thought of it that way. However, I think the issue is that for valuing a long-term stream of cash flows, what matters is not what the market will return this year, or next, but what the average long-term return of the market is going to be. Therefore for computing the cost of capital from a “required return” or corporate finance perspective, you want the market return of the market over a typical business cycle, not simply what you think will happen next year. If you have a really good model that can project the market’s return over the next 5 or 10 years, then great, you can use a different required return for each year, but absent that, you want to be doing long term averaging - i.e. what will the annualized ERP be over the next 10 years. dieselbp67 Wrote: ------------------------------------------------------- > 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.
I agree with bchadwick, I think in your example, the drop in the expected market return from 10% to 5% is rather unjustified. The equity risk premium here is long-horizon. Academics can keep arguing how long is long, but a downward or upward business cycle should not have such a dramatic effect, some mean-reversion is definitely in place
> DOW is cooking, everybody is getting 10% Make that “_was_ getting”. Until they repeal the business cycle, the usual expectation is that when prices are high, future returns will be lower. (This is what Buffet means when he says: “If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case.”) So though recent historical return was 10%, expected return has dropped to 5%. So in your analysis you reversed the two E® values. Of course this all requires your adopting the view that, over the long run, firms’ cash flows are independent of the business cycle. > what will the annualized ERP be over the next 10 years So I think I’m disagreeing with bchadwick, who appears to be arguing that Ke should be stable over time (a long-term average). I think instead that Ke varies (inversely with the current point in the business cycle).