Cost of equity

The Cost of Capital

• To value a company using enterprise DCF, we discount free cash flow by the
weighted average cost of capital (WACC). The WACC represents the
opportunity cost that investors face for investing their funds in one particular
business instead of others with similar risk.

• In its simplest form, the weighted average cost of capital is the market-based
weighted average of the after-tax cost of debt and cost of equity:

D E
WACC  k d (1  Tm )  ke
V V
• To determine the weighted average cost of capital, we must calculate its
three components: (1) the cost of equity, (2) the after-tax cost of debt, and
(3) the company’s target capital structure.

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 Successful Implementation Requires Consistency

• The most important principle underlying successful implementation

of the cost of capital is consistency between the components of
WACC and free cash flow. To ensure consistency,
– It must include the opportunity costs of all investors—debt, equity, and so on—
since free cash flow is available to all investors, who expect compensation for
the risks they take.
– It must weight each security’s required return by its target market-based weight,
not by its historical book value.
– Any financing-related benefits or costs, such as interest tax shields, not included
in free cash flow must be incorporated into the cost of capital or valued
separately using adjusted present value.
– It must be computed after corporate taxes (since free cash flow is calculated in
after-tax terms), based on the same expectations of inflation, and match the
duration of the cash flows.

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 The Cost of Capital: An Example
• The weighted average cost of capital at UPS equals 8.0 percent. The
majority of enterprise value is held by equity holders (85.0 percent), whose
CAPM-based required return equals 8.9 percent. The remaining capital is
provided by debt holders at 3.1 percent of an after-tax basis.

UPS: Weighted Average Cost of Capital

%

After-tax Contribution to
Source of Proportion of Cost of Marginal cost of weighted
capital total capital capital tax rate capital average
Debt 15.0 4.9 37.1 3.1 0.5
Equity 85.0 8.9 8.9 7.5
WACC 100.0 8.0

Let’s examine the components of WACC

one by one, starting with the cost of equity…

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 1. The Cost of Equity
• To estimate the cost of equity, we must determine the expected rate of return of the
company’s stock. Since expected rates of return are unobservable, we rely on asset-
pricing models that translate risk into expected return.

• The three most common asset-pricing models differ primarily in how they define risk.

• The capital asset pricing model (CAPM) states that a stock’s expected return is
driven by how sensitive its returns are to the market portfolio. This sensitivity is
measured using a term known as beta.

• The Fama-French three-factor model defines risk as a stock’s sensitivity to three

portfolios: the stock market, a portfolio based on firm size, and a portfolio based on
book-to-market ratios.

• The arbitrage pricing theory (APT) is a generalized multifactor model, but

unfortunately provides no guidance on the appropriate factors that drive returns.

• The CAPM is the most common method for estimating expected returns, so we begin our
analysis with that model.

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 Capital Asset Pricing Model

• A stock’s expected return is driven by three components: the

risk-free rate, beta, and the expected market risk premium.

Estimating the Cost of Equity Using the CAPM

Data requirements Considerations E[ R i ]  rf   i ( E[ R m ]  rf )

• Risk-free rate Use a long-term government rate dominated
in the same currency as cash flows.

Expected Expected
• Market risk premium The market risk premium is difficult to
return market
measure. Various models point to a risk
of stock i risk premium
premium between 4.5 percent and 5.5 percent.
Risk-free Stock’s
• Company beta To estimate beta, lever the company's
rate beta
industry beta to the company's target debt-to-
equity ratio.

6
 Risk-Free Rate: 10-Year Local Treasury

• The cost of capital must be in the Government Zero Coupon Yields, May 2009
same currency as the company’s
5
financials. Thus, use a risk-free

Yield to maturity (percent)

rate posted by the local central
4 German
Eurobond
zero coupon bonds
bank of the company’s 3

country/region. 2 U.S.
Treasury
STRIPS
• The cost of capital must match the 1

duration of the cash flows in 0

0 5 10 15 20

question. For long-term project

valuation and company evaluation, Years to maturity

Source: Bloomberg.
use no less than the 10-year rate.

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 2. The Market Risk Premium

• Sizing the market risk premium—the difference between the market’s

expected return and the risk-free rate—is arguably the most debated
issue in finance.

• Methods to estimate the market risk premium fall into three general
categories:
1. Estimating the future risk premium by measuring and extrapolating
historical returns.

2. Using regression analysis to link current market variables, such as the

aggregate dividend-to-price ratio, to project the expected market risk
premium.

3. Using DCF valuation, along with estimates of return on investment and

growth, to reverse engineer the market’s cost of capital.

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Using Historical Excess Returns: Best Practices
• To best measure the risk premium using historical data, you should:
– Calculate the premium over long-term government bonds.
• Use long-term government bonds, because they match the duration of a company’s cash
flows better than do short-term rates.

– Use the longest period possible.

• If the market risk premium is stable, a longer history will reduce estimation error. Since no
statistically significant trend is observable, we recommend the longest period possible.

– Use an arithmetic average of longer-dated intervals (such as five years).

• Although the arithmetic average of annual returns is the best predictor of future one-year
returns, compounded averages will be upward biased (too high). Therefore, use longer-
dated intervals to build discount rates.

– Adjust the result for econometric issues, such as survivorship bias.

• Predictions based on U.S. data (a successful economy) are probably too high.

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The Market Risk Premium for Holding Stocks

Average Annual Returns

1926− 2008
• Over the past 82 years, the
Large Stocks 11.1%
S&P 500 index has earned
on average a 11.1 percent Small Stocks 15.1%

annual return.
Corporate Bonds 5.8%
• The S&P 500 has earned
5.2 percent more than Government Bonds 5.9%

long-term government
Treasury Bills 3.6%
Treasuries (known as the
market risk premium). Inflation 3.0%

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 When Possible, Use Long-Dated Holding Periods

To correct for the bias caused by misestimation and/or negative autocorrelation in returns, we
have two choices. First, we can calculate multiperiod holding returns directly from the data,
rather than compound single-period averages.
Alternatively, we can use an estimator proposed by Marshall Blume, one that blends the
arithmetic and geometric averages.
Cumulative Returns for Various Intervals, 1900 –2014
%
Average cumulative returns Annualized returns
U.S. U.S. U.S.
U.S. government excess excess Blume
Arithmetic mean of stocks bonds returns returns estimator
1-year holding periods 11.4 5.5 6.4 6.4 6.4
2-year holding periods 24.1 11.2 12.7 6.2 6.3
4-year holding periods 52.1 23.7 25.4 5.8 6.3
5-year holding periods 68.6 30.8 32.6 5.8 6.3
10-year holding periods 175.4 73.8 71.6 5.5 6.2

Source: Dimson Marsh, and Staunton (1900-2002) and Morningstar SBBI (2003-2014)

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 Embedded Market Risk Premium

• Using the key value driver formula, we

can reverse engineer the cost of equity.
Real and Nominal Expected Market Returns, 1962-2013
• After inflation is stripped out, the %

expected market return (not excess

20
return) is remarkably constant in the
United States, averaging 7 percent. For 16

the United Kingdom, the real market 12

Nominal
expected
return
return is slightly more volatile, averaging
8 Real
6 percent. expected
return
𝑔 4
Earnings (1− )
ROE
Equity Value = 0
𝑘𝑒 −𝑔 1962 1972 1982 1992 2002 2012

• To determine the market risk premium,

subtract the real interest rate from the
real cost of equity using Treasury
inflation-protected securities (TIPS).

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 3. Estimating Beta

• According to the CAPM, a stock’s

expected return is driven by beta, UPS: Stock Returns, 2009–2012
which measures how much the %

stock and market move together. 25

20
Since beta cannot be observed
15
directly, we must estimate its
10

UPS monthly stock returns

value. 5

• The most common regression 0

-20 -15 -10 -5 0 5 10 15 20
-5
used to estimate a company’s raw
-10
beta is the market model: Regression beta = 0.98
-15

-20
Ri  a  βRm   -25

-30
• Based on data from 1998 to 2003, Morgan Stanley Capital Index (MSCI) global monthly returns

Home Depot’s beta is estimated

at 0.98.

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 Beta Varies over Time

• Between 1985 and 2008, IBM’s IBM: Market Beta, 1985-2010

beta hovered near 0.7 in the
2.0
1980s but rose dramatically in
the mid-1990s to a peak above 1.6 services

Market beta
1.7 before falling back down. It
1.2
now measures near 0.8.
• This rise in beta occurred 0.8

during a period of great change hardware

0.4
for IBM, as the company
moved from hardware (such as 0.0
1986 1991 1996 2001 2006
mainframes) to services (such
as consulting).

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 Estimating Beta: Best Practices

• As can be seen on the previous slide, estimating beta is a noisy process. Based on
certain market characteristics and a variety of empirical tests, we reach several
conclusions about the regression process:

– Raw regressions should use at least 60 data points (e.g., five years of monthly
returns). Rolling betas should be graphed to examine any systematic changes in a
stock’s risk.

– Raw regressions should be based on monthly returns. Using shorter return periods,
such as daily and weekly returns, leads to systematic biases.

– Company stock returns should be regressed against a value-weighted, well-

diversified portfolio, such as the S&P 500 or MSCI World Index.

• Next, recalling that raw regressions provide only estimates of a company’s true beta, we
improve estimates of a company’s beta by deriving an unlevered industry beta and then
relevering the industry beta to the company’s target capital structure.

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 Measuring Beta Using Peer Groups

• The Ibbotson “Beta Book” provides raw regression betas and peer
group betas.

• To determine peer group betas, Ibbotson examines pure plays and

conglomerates, using a methodology pioneered by Kaplan and
Peterson…. Sales Sales Sales
Raw beta i  1
x1  2
x2  3
x3  ...
Sales i Sales i Sales i such that x1 is the “pure play”
beta for industry 1, x2 is the
Sales1 Sales 2 Sales 3
Raw beta j  x1  x2  x3  ... beta for industry 2…
Sales j Sales j Sales j

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 Operating Risk across Industries

Unlevered Beta Estimates by Industry

• A company’s beta
Industry Beta range
represents the company’s Electric utilities 0.5 - 0.7
Healthcare providers 0.7 - 0.8
exposure to changes in Integrated oil and gas 0.7 - 0.8
Airlines 0.7 - 0.9
the overall stock market. Consumer packaged goods 0.8 - 0.9
• Since the stock market is Pharmaceutical 0.8 - 1.0
Retail 0.8 - 1.0
closely tied to the Telecom 0.8 - 1.0
Mining 0.9 - 1.0
economy, a company’s Automotive and assemblers 0.9 - 1.1
beta represents its Chemicals 0.9 - 1.1
IT services, hardware 0.9 - 1.1
revenue and cash flow Software 0.9 - 1.1
Banking 1.0 - 1.1
exposure to the Insurance 1.0 - 1.1
economy’s strength. Semiconductors 1.0 - 1.3

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 Cost of Equity Using CAPM

• When the beta is high, the 14.4%

stock is considered more Above
risky than the market. Average
Cisco
• For instance, Cisco Systems Risk
(10.4%)
Expected
moves more than the market, 9.2% market
return
and has a beta of 1.86. Raytheon Below
(7.8%) Average
Thus, the company’s cost of
Risk
equity is 10.4 percent.
Risk-free
4.0% rate
• With a beta of 0.73,
Base Return
Raytheon’s cost of equity is Long-Term
estimated at 7.8 percent. Treasuries

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