If you really want to know what will happen to stock prices, look no further than the cost of equity, also known as the discount rate.
Put simply, this arcane-sounding metric is a stock investor’s return requirement for making a particular investment. The more the risk, the higher the expected return.
But the real question is: How should investors measure risk?
Academics believe it should generally be tied to the risk-free rate like the 10-year Treasury yield, plus a mark-up for the volatility of the stock.
They’re wrong, and here’s why it is important:
A change in perceived risk significantly alters a firm’s fair value, even when current free cash flow and growth rate remain unchanged.
For example, a one percentage point rise in a company’s cost of equity to 9% from 8% equals a one percentage point rise in risk. That one percentage point rise in risk, in turn, translates into a staggering 25% decline in fair value. If the company’s risk rises further – to, say, a 12% cost of equity — the fair value should be expected to fall by 57%.
That’s why the cost of capital is so important. If a company’s cost of capital rises, its share price, must, by definition, fall until it reaches its new lower fair value, as shown in the following table.
In general, risk is measured by the uncertainty of the firm’s future free cash flows. Free cash flows are, in essence, the income to the investor; they represent the maximum amount of cash the firm could distribute without impairing its growth.
Sure, analysts use other measures to arrive at fair value, including market value of the individual parts, liquidation value, price/sales, price/earnings, or price/book. Book value has proven to be an unreliable metric if the book consists of assets where buyers at fair market prices are absent. What is the value of an asset for which there are either no buyers or buyers at unreasonably low prices?
It is the free cash flows, which must then be discounted. But at what rate?
In order to arrive at a fair value estimate for an equity security, an analyst or investor must discount the firm’s free cash flow by a rate equal to the perceived risk. And the risk is a reflection of the uncertainly of the free cash flows. Treasuries will be discounted at the risk free rate plus a small mark-up for the loss of its investment grade status. The amount of the markup is up to the analyst.
That’s why estimates of free cash flow and earnings are called estimates. And because they’re estimates, they’re at the whim of such risks such as the loss of patents or customers, volatility in input costs, litigation, inadequate insurance (e.g., BP was self-insured), foreign government-related issues and rollover of debt, whatever. These risks must be captured by the cost of equity. The fewer and less serious these risks are, the more certain we can feel about the free cash flows. For such an enterprise with above average normalized free cash flow and moderate leverage, lower cost of equity will normally place the entity in a position to add value-adding projects with more facility than its competitors.
The ability to assess risk to the free cash flows through the adjustment of the cost of equity (discount rate) will provide you with a tool which will place you head and tails over just about every securities analyst you see on CNBC or elsewhere. I can also assure you that over the coming years you will be hearing and reading a lot about the appropriate setting of the cost of capital.
So where do things stand now?
According to our comprehensive credit model, and, as outlined in my text, “Security Valuation and Risk Analysis”, the fall in yield spreads, sovereign risk, improvement in credit strength, and rise in free cash flows, have reduced the cost of equity capital to 7.9% for the S&P Industrials from 8.3% a year earlier. Thus, one should expect a 7.9% return for the S&P over the next year, based on the current level of risk.
So, next time your hear during a company presentation or read in an analyst’s report a cash flow estimate, make sure you understand all of the potential risks to the forecast, made possible through a thorough reading of all SEC filings, for in so doing, your expected return will not only shift, but be more realistic.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.