Cost of equity capital and required rates of return for shareholders

¶ … Popular Cost of Equity Models: Problems and Potentials in Current Theory and Practice

It is important for any publicly traded business organization to understand and accurately estimate its cost of equity capital, in order to make effective capital-raising resource allocation decisions. There are several models for determining a supposedly accurate valuation for the current cost of equity capital for a given firm, however each of these models is imperfect in its approach and its ultimate assessment. The following pages provide an overview of three popular models for providing this valuation, assessing the models base don ease of use, accuracy of the prediction, and the degree to which the assumptions made or implied by the model are reflective of reality and actual operational capabilities. A final recommendation for a particular model is made following this assessment.

Ease of Use

One of the most straightforward methods for estimating the cost of equity capital, or the rate of return that investors require, is the dividend growth model. By measuring the present value of all future dividend payments to an investor on one share of company stock, the value of the stock to the investor can be determined, according to this model (Pages.stern.nyu.edu, n.d.). As dividend payments are the only true cash flow investors receive from stock ownership, this valuation model takes the simple and direct approach of measuring the present value of these payments, and is very easy to use and apply (Pages.stern.nyu.edu, n.d.).

The capital asset pricing model is slightly more complex than the dividend growth model of cost of equity capital estimation, but is still relatively straightforward. Instead of calculating the present value of future expected dividends or the explicit cash flow investors receive, this model examines measures of risk based on current trends in the market to determine how the value of a stock -- the share price, that is -- might change (Investopedia, 2012). Establishing a beta coefficient that stands as a measure of how closely the stock price correlates with market trends allows for the projected change in stock price based on expected market changes and more stable instruments, typically U.S. Treasury Bonds (Investopedia, 2012). Establishing the specific components of the capital asset pricing formula can be somewhat difficult, however if these figures are known the model is very easy to use.

Arbitrage pricing theory attempts to take both market factors and internal factors that are specific to the business or company being examined, using a formula that is very similar to that used for the capital asset pricing model but with more terms and therefore greater complexity (Moneyterms, 2012). The risk free rate of return is compared to each of the identified internal factors multiplied by a beta coefficient that measures how this factor relates to company performance, based on an assessment of past performance and evidence of influence (Moneyterms, 2012). Because there is no specific limitation for the number or type of factors that can and should be included in the arbitrage pricing formula for any specific company, this is the most complex and difficult to implement of the pricing models discussed herein.

Accuracy

The accuracy of each of these models might seem to be directly related to the complexity of each model, and indeed at first glance this makes a great deal of sense. The dividend growth model takes only one specific factor into account, and with the dividend-to-share price ratio of most companies and the rate of trades that most investors make, this is not really the most accurate measure of how stockholders derive value from their purchases and therefore might not be the most accurate measure. This gets into the area of assumptions inherent to each of these systems, however, which will be discussed in greater detail below. In terms of true measurable accuracy, this model can be said to be the most accurate as it does not involve making complex projections for the future but rather makes strict mathematical projections based on concrete company performance and statements of expected dividend payments.

The other two models, the capital asset pricing model and the arbitrage pricing theory, require projections and calculations that are less certain and concrete than measuring the dividend payments regularly given out by companies. Establishing beta coefficients is never an exact science, as this coefficient would change depending on how far back in the company's history one decides to measure, and a multitude of environmental and internal factors can affect the real beta coefficient in future years of the company, as well. The accuracy of these measurements, then, is more in question in terms of the actual capability to measure with certainty, despite the greater level of detail in these models.

Assumptions

The real assessment of the accuracy of these models -- that is, the degree to which they are realistically useful in determining the necessary rate of return for investors in a given company and thus that company's cost of equity capital -- depends upon the assumptions that these various models make. The basic assumptions of the dividend growth model have already been briefly mentioned above; by taking only the future expected dividend payments of equity ownership into account, this model assumes that this is the only (or at least the primary and by far the most important) way in which investors derive and demand value from their stock purchases. As dividend payments do not appear to be a major driver of investor behavior, this basic assumption and the many minor assumptions that are part of it (discounting other factors in value creation) is not very realistic.

This does not mean that the assumptions made by the other models are necessarily much better, however. The capital asset pricing model makes many assumptions, from establishing the "risk-free" rate of return and assuming it will persist at the same rate in the future to the measurement and projection of a beta coefficient to the basic underlying assumption that stock price is the only way in which investors derive value from a stock purchase. The assumptions made in the assessment of a final valuation are more numerous and more complex than in the case of the dividend growth model, yet they do tend to be more realistic on the whole -- at least, the more detailed analysis of value seems a better assumption than basing value solely on dividends.