Businesses increasingly recognise the need to generate returns that exceed their cost of capital. It is now widely appreciated that anything less than that will result in an erosion of shareholder value. But what exactly is the cost of capital? For debt, it’s easy: it’s the cost of servicing that debt – the interest payments. The cost of equity is a more difficult concept – and it’s one that authoritative commentators are confused by as they try to analyse why markets everywhere have fallen out of bed. To resolve these issues, Financial Director turned to Stern Stewart, the consultancy which has almost single-handedly turned the capital asset pricing model (CAPM) into a practical tool for performance measurement, investment appraisal and employee remuneration. First, the cost of equity is not the cost of dividends. The cash payments to investors do not, by themselves, represent the company’s cost of equity. More surprising, perhaps, the cost of equity hasn’t got much to do with a company’s share price, either. A higher share price does not necessarily mean that the cost of equity has gone down. The cost of equity is basically regarded as what shareholders have a right to expect by way of total shareholder returns – dividends plus share price appreciation. This is directly related to the returns available by investing in a risk-free instrument, such as consols – non-repayable government bonds. The formula for the stockmarket as a whole is: Rm = Rf + MRP where: Rm = Expected stockmarket return; Rf = Risk-free rate; and MRP = Market risk premium Statistically, the market risk premium tends to work out at around 5.5% to 6%. But more to the point, what is this formula actually saying? It’s saying that investors expect greater returns than from government bonds because, unquestionably, equities are riskier investments; they require more reward as compensation for their greater risk. For individual companies, the cost of equity is the opportunity cost borne by the investor – the gain foregone – by not investing in something else. Only a slight modification to the above formula is necessary, one that acknowledges that not all equities carry the same degree of risk. For individual companies, therefore, the formula is: Rm = Rf + (beta x MRP) where: beta = the company’s risk index Beta is calculated by plotting the volatility of a share price, relative to that of the market as a whole. If it’s less than 1 then the share is less volatile than the market – and lower growth: a 5% rise in the stockmarket would typically result in a share price rise of less than 5%. Conversely, if beta is greater than 1, then the shares should rise more than 5%. These beta values are available on on-line services such as Datastream/ICV. This adds up to a methodology that says, if a company is perceived as being of lower than average risk, then investors will accept a lower than average return – and vice versa. And that’s it. Note that there is nothing in the formula about dividends as such, nor about the level of the share price, the price/earnings ratio nor its inverse, the earnings yield. “A high growth company may have a high p/e ratio,” says Greg Milano, who heads up Stern Stewart’s European operations from their London office. “But that’s because the higher future profits – (higher, because of the growth of the profits) – discount to a higher present value relative to today’s profits.” It’s an important point, says Milano, because there is a lot of (arguably) ill-informed talk about how current stockmarket weaknesses are due to an increase in the markets’ cost of capital – in effect, an increase in the rate at which future earnings are being discounted – resulting in a lower net present value, ie, a lower share price. In particular, there has been much comment claiming an increase in the market risk premium part of the equation. Milano says that, in fact, it’s not the discount rate that has gone up, but the expected future income stream which has gone down, because of recessionary fears. Milano thinks that, if anything, the cost of equity has gone down, “because the benchmark level of interest rates on long-term government bonds has gone down,” he says. There’s one other point: Stern Stewart’s research has found that about half of all companies earn more than their cost of capital, the other half don’t: “It’s almost a tautology: the cost of capital is the expected return which, on average, is about what the average company produces. If all companies did better over a long period of time, then our market risk premium would be higher. This is something that bothers some people: they say, ‘If every company does better, the cost of capital goes up?’ But yes: if everybody suddenly had better investment opportunities and could create more value, there would be that much more demand for capital, so the price of the capital would go up.” Sound tough? Think of it this way: no matter how much we spend on education, half of this country’s children will be of below average intelligence. More important is how the cost of equity or cost of capital is used by companies. “You shouldn’t say you’re only going to invest in low-risk businesses because that way the cost of capital will stay low,” Milano says. “You shouldn’t invest in a business because it’s high risk or low risk; you should invest in it because you think it will earn a return that more than compensates for the risk.” He adds that some people worry too much about the precision of their cost of equity calculations: “If you think it’s 10%, and it’s really 9.5%, it doesn’t make any difference. People look at you and say, ‘But that’s 50 basis points. If that were a loan, we’d worry about 50 basis points.’ But I think of it as a benchmark for making investment decisions and if you can find somebody who can tell the difference before the investment between a 10% rate of return and a 9.5% rate of return, then I would care. Right now it’s important understand that there is a cost of capital and roughly what it is.”

# Capital ideas about equity’s cost.

Few things are surrounded by as many misconceptions as the concept of the cost of equity. But a quick tour of the business school theory offers a new way of looking at stockmarket weakness.