Toward a New Theory of the Cost of Equty Capital

I have never liked using MPT [Modern Portfolio Theory] for calculating the cost of equity capital for two reasons:

• Beta is not a stable parameter; also, it does not measure risk well.
• Company-specific risk is significant, and varies a great deal. The effects on a company with a large amount of debt financing is significant.

What did they do in the old days? They added a few percent on to where the company’s long debt traded, less for financially stable companies, more for those that took significant risks. If less scientific, it was probably more accurate than MPT. Science is often ill-applied to what may be an art. Neoclassical economics is a beautiful shining edifice of mathematical complexity and practical uselessness.

I’ve also never been a fan of the Modigliani-Miller irrelevance theorems. They are true in fair weather, but not in foul weather. The costs of getting in financial stress are high, much less when a firm is teetering on the edge of insolvency. The cost of financing assets goes up dramatically when a company needs financing in bad times.

But the fair weather use of the M-M theorems is still useful, in my opinion. The cost of the combination of debt, equity and other instruments used to finance depends on the assets involved, and not the composition of the financing. If one finances with equity only, the equityholders will demand less of a return, because the stock is less risky. If there is a significant, but not prohibitively large slug of debt, the equity will be more risky, and will sell at a higher prospective return, or, a lower P/E or P/Free Cash Flow.

Securitization is another example of this. I will use a securitization of commercial mortgages [CMBS], to serve as my example here. There are often tranches rated AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, and junk-rated tranches, before ending with the residual tranche, which has the equity interest.

That is what the equity interest is – the party that gets the leftovers after all of the more senior capital interests get paid. In many securitizations, that equity tranche is small, because the underlying assets are high quality. The smaller the equity tranche, the greater percentage reward for success, and the greater possibility of a total wipeout if things go wrong. That is the same calculus that lies behind highly levered corporations, and private equity.

All of this follows the contingent claims model that Merton posited regarding how debt should be priced, since the equityholders have the put option of giving the debtholders the firm if things go bad, but the equityholders have all of the upside if things go well.

So, using the M-M model, Merton’s model, and securitization, which are really all the same model, I can potentially develop estimates for where equities and debts should trade. But for average investors, what does that mean? How does that instruct us in how to value stock and bonds of the same company against each other?

There is a hierarchy of yields across the instruments that finance a corporation. The driving rule should be that riskier instruments deserve higher yields. Senior bonds trade with low yields, junior bonds at higher yields, and preferred stock at higher yields yet. As for common stocks, they should trade at an earnings or FCF yield greater than that of the highest after-tax yield on debts and other instruments.

Thus, and application of contingent claims theory to the firm, much as Merton did it, should serve as a replacement for MPT in order to estimate the cost of capital for a firm, and for the equity itself. Now, there are quantitative debt raters like Egan-Jones and the quantitative side of Moody’s – the part that bought KMV). If they are not doing this already, this is another use for the model, to be able to consult with corporations over the cost of capital for a firm, and for the equity itself. This can replace the use of beta in calculations of the cost of equity, and lead to a more sane measure of the weighted average cost of capital.

Values could then be used by private equity for a more accurate measurement of the cost of capital, and estimates of where a portfolio company could do and IPO. The answer varies with the assets financed, and the degree of leverage already employed. Beyond that, CFOs could use the data to see whether Wall Street was giving them fair financing options, and take advantage of finance when it is favorable.

I’ve wanted to write this for a while. Though this is an outline of how to replace MPT in estimating the cost of capital, it has broader ramifications, and could become a much larger business, much like the rating agencies started with a simple business, and branched out from there.

Maybe someone is doing this already. If you are aware of that, let me know in the comments.

Comments

[Clive Corcoran:]

I share your view that beta is not an adequate way of measuring risk but I am not sure that there are any good ways.
Standard deviation is flawed for many reasons having to do with "fat tails" as well as the sequencing of returns (i.e. volatility and "bad" returns tend to cluster).
The most useful measure that I have encountered is to relate the risk of holding an asset with the likelihood and severity of drawdowns.
The Calmar ratio divides returns by the maximum drawdown experienced and for most investors/traders that most captures the "discomfort" and also allows for the best inter-market and inter-asset comparisons.

Oct 19 08:38 AM

[Tom Armistead:]

My interest in the subject would be developing the weighted average cost of capital in order to evaluate equities on a DCF basis. Sometimes it seems to me that analysts who rely primarily on DCF for valuation fiddle with the weighted average cost of capital to keep their estimates closer to the market price.

For example, I recently saw an analyst use 13% weighted averaged cost of capital for a company with no debt, in point of fact they had a huge cash surplus. So if a company doesn't have to raise money what is their cost of capital?

At times the reasoning develops a certain circularity, the share prices are low so the implied cost of capital is high therefore the DCF yields a low target value. The whole thing is WACCed out.

Oct 19 10:33 AM

[jimmy46:]

Forgive me, but either I don't understand what you're saying or you're contradicting yourself.

First you quote Merton:
"since the equity holders have the put option of giving the debt holders the firm if things go bad,
but the equity holders have all of the upside if things go well."

Then you say:
"As for common stocks, they should trade at an earnings or FCF yield greater than that of the highest after-tax yield on debts and other instruments."

Are you forgetting to value that Put option?
Having all the upside, even if it often doesn't realize, is worth a lot.

Enough that I rarely buy bonds.

Oct 19 04:37 PM

[ObjectiveFu...:]

Remember that "cost of capital" isn't just the (average) cost to raise new capital in the markets. It is also the "opportunity cost of capital", i.e. the point at which you're better off taking your project dollars (in your example, operating cash) and investing them externally (i.e. in a diversified bundle of stocks and bonds) instead of in your company's projects. That's why it's often referred to as a "hurdle rate".

On Oct 19 10:33 AM Tom Armistead wrote:

For example, I recently saw an analyst use 13% weighted averaged cost of capital for a company with no debt, in point of fact they had a huge cash surplus. So if a company doesn't have to raise money what is their cost of capital?

Oct 20 03:40 PM