Working as an equity analyst one of the most important
questions to ask is ‘Is this company beating its cost of capital?’ Ultimately if a company fails to do this over
time then it will cease to exist, albeit with one or two rescue rights along
the way.
What is the most accurate way to estimate a company’s cost
of capital? This has been the subject of
much debate recently and there have emerged several conflicting schools of
thought. What is agreed is that this metric
must be nailed if companies are to be valued with any confidence. Too many times as a professional investor I
came across analysts willing to use arbitrary or ill-conceived costs of capital
to discount future cash-flows and justify fair value opinions. I think the term ‘rubbish-in rubbish-out’ was coined
for sell-side DCF modelling.
The cost of capital is the weighted average of the cost of
debt and the cost of equity (COE). The
cost of debt is the interest rate that the company pays on its existing
borrowings. Traditionally, the COE is derived
from modern portfolio theory (MPT) and is essentially the risk free rate plus a
company specific equity risk premium.
The risk free rate is considered to be the local government bond… let’s
stop there. As you can see the
controversy has already begun. Another key
tenet of MPT is ‘beta’ which, when multiplied by market risk, is supposed to estimate
company specific risk. In fact, beta is
a measure of historic share price volatility and has been widely criticised as
inappropriate.
The build-up method is an alternative for estimating COE and
is often used for small caps and privately held companies to whom presumably
modern portfolio theory does not apply.
Here, components of systematic risk (market, size) and specific risk (industry
sector, balance sheet, liquidity, control) are added to the risk free rate to
build up the COE. Share price volatility
is not used as a proxy for risk in this method which is a major advantage.
A key issue is that these methods rely on empirical data or the
‘rear view mirror’ to estimate future risk.
Each component is derived from an historical data series. Even if very long-term series are used,
backward looking fallacies can occur. I
really like the following quote from Taleb’s Fooled by Randomness (pp.
55-56): “Things are always obvious after the fact… It has to do with the way
that our mind handles historical information. When you look at the past, the
past will always be deterministic, since only one single observation took
place.”
‘Real world’ cost of capital calculations are gaining
credibility and can be readily applied to privately held companies. Here the cost of debt is the actual coupon
rate the company would pay if it raised debt today from an external source such
as a bank. Cost of equity is trickier
but can be estimated by surveying the required returns of venture capital
companies or derived from the expected selling price if the company was placed today
on the open market. Although this
approach is more pragmatic, the results it produces will always be driven by
the availability or scarcity of finance capital at any point in time.
Further Reading
