Cost of equity-How to define/determine ?

Buddies here by dividend yield or other financial measures ?

(01-04-2014, 08:01 PM)Stocker Wrote: Buddies here by dividend yield or other financial measures ?

Hi Stocker, you may refer to this link.

http://www.miniwebtool.com/cost-of-equity-calculator/

More than 2K members but only one bothered to reply.
Question not serious ?

I only use prevailing yield.

There are various ways to estimate cost of equity

1) Gordon growth model style used in the link provided by winx above. Not useful for non dividend paying stocks and estimates seem low for many companies.

2) Capm model. The most robust of the models. Requires many estimates thus creating more modeling risk.

3) Earnings yield (eps/p) or free cash flow yield (fcf per share/p). When people use p/e or p/fcf ratios they are implicitly doing something rather similar.

Not any of the models, earnings yield closest though not exactly bcos doesnt factor growth. CAPM is the worst since its based on beta (academic term for risk) which basically measures volatility of share price against market.

In essence, it is the opportunity cost of an investor's capital. The important to ask is what rate of return that could have been earned by putting the same money into a different investment with equal risk.

Coca-cola had it at 16% when robert goizueta was CEO(read fortune article for coke in 1987).

On a current basis, if the S&P500 is currently priced at 1x book and ROE is at 15%, your current cost of equity is then 15%.

But because you invest for the long term, when the long term nominal returns is 10%, your cost of equity should be around this region. Of course there will never be any specific number to discount your cash with but its always a very rough number and this number is good enough to couple with a whole lot of other factors.

If you are a manager keeping track of your business, assuming you are funded purely by equity with no debt, you ask yourself how much does inventory cost for your business. The difference between keeping 10K dollars worth of inventory is that it costed you your cost of capital in holding those inventory, albeit some are necessary while others are not. So good business management reduce holding inventories to minimise unnecessary opportunity cost. This was what bill anders did at General Dynamics did.

Cost of equity is a very subjective and depends on how you want to look at it for the simple reason, owners don't demand a guaranteed return from stocks unlike bonds.

2 simplest way for investors to guess cost of equity:

1) Like how Scottleey said, calculating returns of equity over last 10 years. Assumption is if the return is too low, the shareholders will pull funds from the company which is absolutely not true
2) Use risk free rate + risk premium, i.e. SG govt yield + a risk premium u deem the company is in. Structure of industry, leverage ratio, etc.

Thanks Buddies who spent your times to share.

Your question has two parts, how to define it, and how to determine it.

Define it:
As other posters have mentioned, the best way to understand the cost of equity is to relate it to the required rate of return for shareholders. It's especially important because we discount projected cash flows to equity by the cost of equity to get the our share price. Alternatively, the more common approach of using cash flows to firm and discounting by the WACC (of which cost of equity is a component) is used.

Specifically, it is the return a shareholder must receive for holding that piece of equity, and is equal to the shareholder's required rate of return on a similar investment of the same risk profile. Once you equate it to required rates of return, you will realise that the cost of equity is dynamic and dependent on investor sentiment- during times when there is plenty of demand for stocks, prices go up and the required rates of return go down, your cost of equity of a given security is low. When there is a lack of demand, prices for stocks fall and your cost of equity goes up.

This also explains why companies prefer to issue shares during frothy markets (when the cost of equity is low) rather than during bear markets.

Example: Large, dominant companies like Coca Cola or GE have barriers to entry, strong earnings power, low net debt, and positive cashflows that can be (more) reliably predicted. Investors understand these strengths reduce the risk of loss on their investments and the required rate of return (and therefore the cost of equity) on the stock is hence low. For your latest biotech stock peddling HCV drugs, where cashflows are determined by adoption and FDA approval, and where binary outcomes are more likely, your required return for investing in the stock will not be 8-9%. (or around 6% in this environment) You will demand a premium for the additional risk you are taking, so your cost of equity is higher at say, 20%.

Determine it:

Now that we have a conceptual understanding of what the cost of equity is, the next step is not so much to determine it, but rather to estimate it. Other posters have done a good job of outlining the various ways to estimate your cost of equity- your CAPM and dividend growth models are the most taught and well-known. (a quick google search will teach you how to calculate it using both methods)

Clement is right in that the dividend growth model seems to be on the low side- many firms do not pay dividends (rendering this model useless in these cases), and we face difficulty in anticipating the dividend growth rate into perpetuity. A large group of investors also expects their returns from price increases rather than dividend income. This model is useful for stable companies bought primarily for their dividend yield and which dividend growth can be estimated from history (e.g. telcos and utilities). For others, it provides a lower bound on your cost of equity estimate.

The most widely agreed (among academics) is to use the CAPM model to calculate your cost of equity. Whether volatility is a good indicator of risk and return is up to debate, but not the subject of this discussion. The following website provides a rough guide to the CAPM-calculated cost of equity for various industries (US-based):
http://pages.stern.nyu.edu/~adamodar/New...e/wacc.htm

In practice, some investors i know use an arbitrary cost of capital (and equity). E.g. 20% for microcaps, 15% for small caps, 12% for mid caps, and 10% for large caps. They use the CAPM and the Dividend Growth model as a sanity check/guideline. Others target a 15% return for their funds, and so use a standard 15% cost of equity across all their models. That works, though it creates a bias towards smaller cap, 'riskier' stocks.

Back to valuation, which I presume is the point of estimating your cost of equity- let's say you complete your DCF model for company X, which is trading at $40 and discover that share X is undervalued. Your DCF model says it should be worth $80. The analysts working at Fidelity, Wellington, Goldman, etc have presumably also done their homework and DCF models, which has led to its current share price of $40. Broadly speaking, this discrepancy must come from two things- either you estimated 1) higher cash flows for company X in the future, or 2) your input WACC/Cost of equity is lower. Both are valid reasons for investing. (1) means you expect higher returns from the company than the market (whether you did primary research or have inside info), which justifies a higher price. (2) means you believe this security/environment isn't as risky as others believe it is, and in time this unloved security will be accepted by the market and its WACC will decrease.

My point is the price you calculate from your DCF isn't just very sensitive to your WACC/cost of equity. It is inversely related and conceptually linked to your share price. You should pay particular attention to and deeply understand why you choose a different Cost of Equity from the market (which presumably uses CAPM). Otherwise, the CAPM and dividend growth model serve as great guidelines.

^^great first post

As mentioned cost of equity is an estimate of whether project is positive or negative share price. That has implications. This means it is mainly for minorities.

Major shareholder and the CFO don't look at cost of equity from the way we look at it. Cost of debt is easy to ascertain, but cost of equity is more an art on how much future benefit I am willing to forego as a major shareholder vs putting in more cash