Chapter 11

The Opportunity Cost of Capital:

The Cost of Equity
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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:
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 companys target capital structure.
e m d
k
V
E
T k
V
D
+ = ) (1 WACC
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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 investorsdebt, 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 securitys 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 Home Depot equals 8.5 percent.
The majority of enterprise value is held by equity holders (68.5 percent),
whose CAPM-based required return equals 10.4 percent. The remaining
capital is provided by debt holders at 4.2 percent of an after-tax basis.
Lets examine the components of WACC
one by one, starting with the cost of equity
percent
After-tax Contribution to
Source of Proportion of Cost of Marginal opportunity weighted
capital total capital capital tax rate cost average
Debt 31.5 6.8 37.6 4.2 1.3
Equity 68.5 10.4 10.4 7.1
WACC 100.0 8.5
Home Depot: Weighted Average Cost of Capital
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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
companys 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 stocks 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 stocks 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.
Capital Asset Pricing Model
A stocks expected return is driven by three components: the
risk-free rate, beta, and the expected market risk premium.
) ] [ ( ] [
f m i f i
R R E B R R E + =
Expected
return
of stock i
Expected
market
risk premium
Risk-free
rate
Stocks
beta
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Estimating the Cost of Equity Using the CAPM
Data requirements Considerations
Risk-free rate Use a long-term government rate dominated
in the same currency as cash flows.
Market risk premium The market risk premium is difficult to
measure. Various models point to a risk
premium between 4.5 percent and 5.5 percent.
Company beta To estimate beta, lever the company's
industry beta to the company's target debt-to-
equity ratio.
Risk-Free Rate: 10-Year Local Treasury
The cost of capital must be in the
same currency as the companys
financials. Thus, use a risk-free
rate posted by the local central
bank of the companys
country/region.
The cost of capital must match the
duration of the cash flows in
question. For long-term project
valuation and company evaluation,
use no less than the 10-year rate.
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Source: Bloomberg.
0
1
2
3
4
5
0 5 10 15 20
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(
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)
Years to maturity
German
Eurobond
zero coupon bonds
U.S.
Treasury
STRIPS
Government Zero Coupon Yields, May 2009
2. The Market Risk Premium
Sizing the market risk premiumthe difference between the markets
expected return and the risk-free rateis 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 markets 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 companys 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.
The Market Risk Premium for Holding Stocks
Over the past 82 years, the
S&P 500 index has earned
on average a 11.1 percent
annual return.
The S&P 500 has earned
5.2 percent more than
long-term government
Treasuries (known as the
market risk premium).
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11.1%
15.1%
5.8%
5.9%
3.6%
3.0%
Large Stocks
Small Stocks
Corporate Bonds
Government Bonds
Treasury Bills
Inflation
Average Annual Returns
1926 2008
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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 2009
percent
U.S. U.S. U.S.
U.S. government excess excess Blume
Arithmetic mean of stocks bonds returns returns estimator
1-year holding periods 11.2 5.4 6.1 6.1 6.1
2-year holding periods 23.7 11.1 12.3 6.0 6.1
4-year holding periods 50.8 23.7 24.4 5.6 6.0
5-year holding periods 66.5 30.7 31.0 5.5 6.0
10-year holding periods 170.7 73.7 69.1 5.4 5.9
Source: Morningstar SBBI data, Morningstar Dimson, Marsh, Staunton Global Returns data.
Annualized returns Average cumulative returns
Embedded Market Risk Premium
Using the key value driver formula, we
can reverse engineer the cost of equity.
After inflation is stripped out, the
expected market return (not excess
return) is remarkably constant in the
United States, averaging 7 percent. For
the United Kingdom, the real market
return is slightly more volatile, averaging
6 percent.
e
g
Net Income 1-
ROE
Price =
k -g
| |
|
\ .
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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0
4
8
12
16
20
1962 1972 1982 1992 2002
Real and Nominal Expected Market Returns
Implied k
e
in real terms
Implied k
e
in nominal terms
3. Estimating Beta
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According to the CAPM, a stocks
expected return is driven by beta,
which measures how much the
stock and market move together.
Since beta cannot be observed
directly, we must estimate its
value.
The most common regression
used to estimate a companys raw
beta is the market model:
c + + =
m i
R a R
Based on data from 1998 to 2003,
Home Depots beta is estimated
at 1.37.
percent
-25
-20
-15
-10
-5
0
5
10
15
20
-20 -15 -10 -5 0 5 10 15 20
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s
Morgan Stanley Capital Index (MSCI) global monthly returns
Regression beta= 1.28
Home Depot: Stock Returns, 20012006
Even though Home Depot matched the market in aggregate losses during 2007 and 2008 (37 percent for
Home Depot versus 35 percent for the MSCI World Index), a slight difference in timing caused the two
measures to be uncorrelated. Prior to 2007, Home Depots market beta was relatively stable. For this
reason, we measure unlevered beta as of 2006.
Beta Varies over Time
Between 1985 and 2008, IBMs
beta hovered near 0.7 in the
1980s but rose dramatically in
the mid-1990s to a peak above
1.7 before falling back down. It
now measures near 0.8.
This rise in beta occurred
during a period of great change
for IBM, as the company
moved from hardware (such as
mainframes) to services (such
as consulting).
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0.0
0.4
0.8
1.2
1.6
2.0
1986 1991 1996 2001 2006
M
a
r
k
e
t

b
e
t
a
IBM: Market Beta, 1985-2010
hardware
services
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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
stocks 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 companys true beta, we
improve estimates of a companys beta by deriving an unlevered industry beta and then
relevering the industry beta to the companys target capital structure.
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
Sales
Sales
Sales
beta Raw
3
3
2
2
1
1
+ + + = x x x
i i i
i
...
Sales
Sales
Sales
Sales
Sales
Sales
beta Raw
3
3
2
2
1
1
+ + + = x x x
j j j
j
such that x
1
is the pure play
beta for industry 1, x
2
is the
beta for industry 2
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Operating Risk across Industries
A companys beta
represents the companys
exposure to changes in
the overall stock market.
Since the stock market is
closely tied to the
economy, a companys
beta represents its
revenue and cash flow
exposure to the
economys strength.
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2.13
1.75
1.55
1.38
1.18
1.12
1.16
1.06
1.00
0.98
0.83
0.63
0.51
Semiconductor Equipment
Life Insurance
Integrated Steel
Specialty Retail
Commodity Chemicals
Information Services
Retail Automotive
Hotel/Gaming
Aggregate Market
Homebuilding
Packaging & Container
Property Management
Water Utility
Unlevered Beta by Sector
Source: Aswath Damodaran, New York University.
Cost of Equity Using CAPM
Base Return
Long-Term
Treasuries
4.0%
Below
Average
Risk
Above
Average
Risk
9.2%
14.4%
Raytheon
(7.8%)
Cisco
(10.4%)
When the beta is high, the
stock is considered more
risky than the market.
For instance, Cisco Systems
moves more than the market,
and has a beta of 1.86.
Thus, the companys cost of
equity is 10.4 percent.
With a beta of 0.73,
Raytheons cost of equity is
estimated at 7.8 percent.
Risk-free
rate
Expected
market
return
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An Alternative Model: Fama & French
In 1992, Eugene Fama and Kenneth French published a paper in the
Journal of Finance that received a great deal of attention because they
concluded,
In short, our tests do not support the most basic prediction of the SLB [Sharpe-Lintner-Black]
Capital Asset Pricing Model that average stock returns are positively related to market betas.
Based on prior research and their own comprehensive regressions, Fama and French
concluded that:
Equity returns are inversely related to the size of a company (as measured by
market capitalization).
Equity returns are positively related to the ratio of the book value to market value of
the companys equity.
With this model, a stocks excess returns are regressed on three factors: excess market
returns, the excess returns of small stocks over big stocks (SMB), and the excess
returns of high book-to-market stocks over low book-to-market stocks (HML).
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An Alternative Model: Fama & French
Lets use the Fama-French three-factor model to continue our Home Depot
example. To determine the companys three betas, Home Depot stock returns
are regressed against the excess market portfolio, SMB, and HML (available
from professional service providers).
Home Depot: Fama-French Expected Returns
For Home Depot, the
Fama-French model
leads to a slightly
smaller cost of equity
than the market model.
Average Average Contribution
monthly annual to expected
premium
1
premium Regression return
Factor (percent) (percent) coefficient
2
(percent)
Market portfolio 5.4 1.39 7.5
SMB portfolio 0.23 2.8 (0.09) (0.3)
HML portfolio 0.40 5.0 (0.14) (0.7)
Premium over risk-free rate
3
6.6
Risk-free rate 3.9
Cost of equity 10.5
1
SMB and HML premiums based on average monthly returns data, 1926 2009.
2
Based on monthly returns data, 2002 2006.
3
Summation rounded to one decimal point.
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An Alternative Model: The Arbitrage Pricing Theory
The arbitrage pricing theory (APT) can be thought of as a generalized
version of the Fama-French three-factor model. In the APT, a securitys
returns are fully specified by k factors and random noise:
e F b F b F b a R
k k i
~
~
...
~ ~ ~
2 2 1 1
+ + + + + =
By creating well-diversified factor portfolios, it can be shown that a securitys
expected return must equal the risk-free rate plus its exposure to each factor
times the factors excess return (denoted by lambda):
k k f i
b b b r R E ... ] [
2 2 1 1
+ + + + =
Implementation of the APT, however, has been elusive, as there is little
agreement on either the number of factors, what the factors represent, or
how to measure the factors.