Two Warnings To Financial Analysts Who Ignore The Economics Of Strategy And Six Empirical Facts Behind Our Warnings. Did You Take Care Of That In Your Pricing Of Assets?

Summary

• Your costs of capital estimates are probably underestimated.
• Are you sure that the cost of capital that you use takes into account the competitive dynamics of the firm?
• The average cost of capital (WACC) from the Dynamic Capital Pricing Model (DCPM) could be much higher than the average cost of capital from the CAPM.

Two warnings to financial analysts:

(1) Your costs of capital estimates are probably underestimated.

(2) Are you sure that the cost of capital that you use takes into account the competitive dynamics of the firm?

Six empirical facts behind our warnings:

1. Our results show that the costs of capital from the CAPM and those from the Dynamic Capital Pricing Model (DMCPM) are significantly different.
2. The average cost of capital from the Dynamic Capital Pricing Model (DCPM) could be much higher than the average cost of capital from the CAPM.
3. The average cost of capital from our Dynamic Capital Pricing Model (DMCPM) is much higher than the average cost of capital from the CAPM for the eight sectors that we have studied.
4. The positive correlation between the market value creation and the marginal return to cost of capital ratio from the model that takes into account the competitive dynamics of the firm, namely the Dynamic Capital Pricing Model (DMCPM), is higher than the positive correlation between the market value creation and the marginal return to cost of capital ratio from the static model, which is the CAPM.
5. Recent results which state a positive relationship between the market value creation and the marginal return to cost of capital ratio support the theoretical framework of Mouelhi and Saint-Pierre (2013) [Available without cost at SSRN: http://ssrn.com/abstract=2266037 ] about which value creation indicator is the most relevant.
6. Overall, recent results show that the Marginal Return to the Cost of Capital ratio, with the cost of capital coming from the Dynamic Capital Pricing Model (DMCPM) has a statistically significantly higher explanatory power regarding the market value creation indicator than the one calculated with the CAPM.

Did you take care of that in your pricing of assets?

The detailed research is available without cost at http://ssrn.com/abstract=2431750

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.