Cost of Equity Capital
KNOWING THE RATE OF RETURN THAT INVESTORS EXPECT FROM YOUR
COMPANY'S STOCK IS ONE OF THE MOST IMPORTANT FACTS YOU CAN OBTAIN TO UNDERSTAND
WHETHER OR NOT YOU ARE MEETING THEIR EXPECTATIONS. With this knowledge, you can
make better decisions in such areas as funding projects, investing in research
and development, pursuing acquisitions, buying back your stock and/or paying
dividends. Despite the importance of this information, companies rarely give
their cost of equity capital calculation the rigorous scrutiny it deserves.
As recent surveys show (see summary below), most companies
use Capital Asset Pricing Model (CAPM) as the preferred practice to estimate
cost of equity capital, but practitioners point to the many weaknesses and
inadequacies of using this model. Some of the major problems identified with
use of CAPM are: (1) wide divergences in estimated equity costs depending on
assumptions deployed, (2) lack of company specific factors in the computation,
and (3) complete dependence on historical data.
DeMarche's cost of equity capital methodology employs exclusive factor model
technology that includes five subfactor groups (style, momentum, liquidity,
firm risk, and industry) and a multi-term structure to quantify your stock's
expected return. In addition, DeMarche's approach is term-structured. We not
only estimate your present cost of equity capital, but also estimate its
anticipated evolution through time by partnering with you to translate how your
company's near-term tactical planning and longer-term strategic planning should
affect changes in your cost of equity. For example, our work has shown that the
market charges a premium to companies with higher financial leverage, greater
earnings volatility and greater sensitivities to certain macro-economic
factors. The same is true of liquidity factors such as small cap size, low
trading volume and low share turnover. DeMarche's factor model allows us to
disentangle these and other risk factors and quantify their impact on your
stock's returns.
This process helps you see, understand and measure the factors that
make up your company's cost of equity capital. Ultimately, this multi-factor
approach may enable you to achieve a lower cost of capital by managing the
factors that affect the market's required rate of return. It is also the basis
for the ability to strategically model your company's future Cost of Equity
Capital, P/E or stock
price. Learn more, too, about our Strategic
Planning.
Cost of Equity
Capital Surveys
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| Survey |
Sampling/Study Description |
Findings/Recommendations |
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Best Practices in Estimating the Cost of Capital: Survey and Synthesis (1)
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Cost-of-capital survey administered to 27 corporations and 10 leading financial
advisers. Seven best selling textbooks and trade books were also analyzed. Best
practice is largely consistent with finance theory. Despite broad agreements at
the theoretical level, however, several problems in application remain that can
lead to wide divergence in estimated capital costs.
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The Capital Asset Pricing Model (CAPM) is the dominant model for estimating
cost of equity capital. Betas are drawn substantially from published sources,
preferring those betas using a long period of equity returns. Some firms use
multi-factor models (e.g., Arbitrage Pricing Theory), but these formed a small
minority. Further applied research on two principal topics is needed. First,
practitioners need additional tools for sharpening their assessment of relative
risk. The variation in company-specific beta estimates from different published
sources can create large differences in capital-cost estimates. Appropriate use
of averages across industry or other risk categories is an avenue worth
exploration. Second, practitioners could benefit from further research on
estimating equity market risk premia. Current practice displays large
variations and focuses primarily on averaging past data. Use of expectational
data appears to be a fruitful approach.
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The Theory and Practice of Corporate Finance: Evidence from the Field (2)
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Survey was sent to
4440 corporate Chief Financial Officers, of which 398 (or 9%) responded. The
survey's primary objectives were to examine current practices in: (1) capital
budgeting; (2) methodology in calculating cost of capital and (3) overall
capital structure.
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The Capital Asset Pricing Model (CAPM) is the most popular method of
determining cost of equity capital. Over 70% of firms responding use this
methodology. The second most popular method is defined as "average of
historical rates of return" on a firm's common stock. The term, historical
rate, was not defined however. These discoveries led the researchers to
conclude "although CAPM is popular, we show that it is not clear that the model
is applied properly in practice. Of course, even if it is applied properly, it
is not clear that the CAPM is a very good model."
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Cost of Capital - Survey of Issues and Trends in India (3)
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Survey was conducted in December 1999. Thirty-four respondents from across
leading Indian companies, lenders, and equity analysts furnished input on cost
of equity, cost of debt, financial leverage and methods of reducing cost of
capital.
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Ninety percent of the respondents used CAPM for computation of cost of equity
capital, mainly due to its application simplicity and popularity. Of those
respondents who used CAPM, three-quarters reported that the beta calculation
does not adequately capture all relevant company specific factors in the
computation of cost of equity. Accordingly, two-thirds of the CAPM users deploy
premia or discounts to adjust CAPM results. The most popular adjustments used
were factors representing business leadership, earnings sustainability, and
quality of management.
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Corporate Finance In Europe - Confronting Theory With Practice (4)
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International survey conducted among 313 CFOs on capital budgeting, cost of
capital, capital structure, and corporate governance. U.S. results obtained by
Campbell and Harvey (2002) were compared with that obtained from the U.K., the
Netherlands , Germany and France.
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In concert with U.S. colleagues, European CFOs determine their cost of capital
using CAPM, rather than applying arithmetic average historic returns or the
dividend discount model. In the U.K., Netherlands, Germany and France, 47.1%,
55.6%, 34%, and 45.2% of CFOs, respectively rely on CAPM for estimating the
cost of equity capital. The second and third popular methods for the European
countries are: (1) the use of average historical returns and (2) the use of
some version of a multi-beta CAPM.
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(1) Best Practices in Estimating the Cost of Capital: Survey
and Synthesis, Bruner, Robert F., Eades, Kenneth M., Harris, Robert S., and Higgins, Robert C., Financial Practice and Education, Spring/Summer 1998, pp. 13-28.
(2) The Theory and Practice of Corporate Finance: Evidence from the Field , Graham, John R. and Harvey, Campbell, Survey sponsored by the Financial Executives International and Duke's Fuqua School of Business, May 2002.
(3) Cost of Capital - Survey of Issues and Trends in India, Ganguli, Ama, and
Puri, Ashwani, PricewaterhouseCoopers - India, Feb., 2000, pp. 10-11.
(4) Corporate Finance In Europe - Confronting Theory With Practice ,
Working Paper, Brounen, Dirk, de Jong, Abe, and Koedijk, Kees, Erasmus Research Institute of Management (ERIM), Erasmus Universiteit Rotterdam, Jan. 2004.
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