Contents - Index

Concept 3:  Cost of Equity Capital
©2009 OS Financial Trading System

For the stock (ke) the most widely used first pass estimate is provided from the Capital Asset Pricing Model (CAPM) estimate.  This implies that ke is a function of three major inputs:
i. Risk free rate (Estimated from US Treasury bonds)
ii. Beta (Measures how much volatility the stock contributes to the market as a whole)
iii. Equity Premium (Excess return expected from stocks over the risk free rate)

i.  First, you can get current estimates for the risk free rate from www.bloomberg.com:  


We will assume a 30-year investor and set Rf = 4.20%
ii. We will work with popular web sites to get an estimate of Beta for IBM from.  For example, MSN Money, Yahoo Investor and Google Finance all provide estimates.  For the current example, beta for IBM was taken from the Google finance site:


Beta = 0.82
MSN displaays a beta equal to 0.82 and Yahoo a beta equal to 0.77.  Taking the average we will use 0.803 as IBM's beta.
iii. The equity premium cannot be observed directly.  Instead it needs to be estimated and we will do this by using historical averages as discussed below.
The average real return from 1872 to 2000 in the US on the S&P500 index is 8.81% (Fama and French, JF April 2002).  If we combine this with the estimate for long term inflation in the US (as discussed in the Normal Growth section above) which equals 3.24% then the long term average equity premium for the US is 5.57%.  As a first pass we will use the estimate of 5.5% however we note that the equity premium fluctuates over time.  For example, in the 1990's it was commonly speculated that the equity premium had declined and some estimates were as low as 3.5%.  For example, interested readers are encouraged to read the speech by Allan Greenspan "Measuring Financial Risk in the 21st Century"
<http://www.federalreserve.gov/BOARDDOCS/SPEECHES/1999/19991014.htm>
Similarly, an interesting paper by Pablo Fernandez at the University of Navarra, has extensively surveyed textbooks and professors to provide international estimates of current equity premiums:
<http://ssrn.com/abstract=1344209>

This paper provides estimates for the Australia, Canada, Europe, UK and US.
Cost of Equity Capital, using CAPM, for IBM
Collecting above together ke = rf + ?i*(E(RM) - rf) = 0.042 + 0.803*0.055  = 0.08657
Current Input Summary:  
FCFE = $9.049 per share.  (input 1)
5-year Abnormal Growth:  11.4%  (input 2).
Normal Growth:  4.5%  (input 3)
CAPM:  Cost of Equity Capital = 0.08657   (input 4)