Why Are the Cost of Common Equity Models Not Matching the Economy?

Sponsored and Written by: Selby P. Jones, III, CRRA, Principal, AUS Consultants

Selby P. Jones, III

The economic recession that the United States, and the rest of the world, is recovering from has caused problems for many individuals as well as businesses. Houses were foreclosed on, excessive debt was hampering the ability of corporations to find sources of capital and jobs were being lost. The fallout of the economic downturn was widespread. Although the U.S. economy has slowly come out of the recession, many think that the country is still in a recession. Some even think that in the near future, the economy of the U.S. could be even worse than when the housing market bubble first burst.  Of course, this is all speculation, but insight into financial and economic theory may provide a clearer idea of what is happening in the U.S. economy and why some things just do not appear to be matching up.

For comparison purposes, financial cost of common equity models, such as the Discounted Cash Flow (DCF) and Capital Asset Pricing Model (CAPM), need to be analyzed to see whether they are accurately and reliably estimated the investor required return, or cost of common equity, in today’s economic environment. The DCF is based upon future cash flows, in the form of dividends plus appreciation in market price upon sale of the common stock. It is also based on the time value of money, i.e., a dollar today is worth less than a dollar in the future. On the other hand, the basic premise of the CAPM is the relationship between risk and return. Beta, or the volatility of a single stocks market return with the volatility of returns on the market portfolio as a whole is critical to the CAPM. Beta risk is known as systematic risk or market risk.  The market beta is assumed to be 1.0. If a company has a beta which is less than 1.0, the company is considered to be less risky than the market and vice-a-versa. Both models utilize company common stock data, either directly or indirectly, causing concern about the low common equity cost rate estimates which these models are providing.

Some of the main assumptions of the DCF are:

  1. Investors discount expected cash flows at the same rate every year;
  2. Dividend, not earnings, constitute the source of value;
  3. There is a constant growth rate that will continue through infinity;
  4. Investors require the same rate every year.

In addition, some of the main assumptions of the CAPM are:

  1. Investors make choices on the basis of risk and return;
  2. There is a risk-free asset and investors can borrow unlimited amounts at that rate;
  3. Risk is measured as the variance of an individual company’s returns with those of the market portfolio.

It is also noted that these assumptions, along with assumptions of models utilizes in and return on equity study, have “loose” assumptions, meaning that strict following of all assumptions of a model is not always possible. Abiding by these loosened assumptions will yield the more appropriate results relative to economic conditions. Based on current estimates derived from the DCF and CAPM, these models do not fall accurately or reliably estimate the investor required return under current economic or capital market conditions.

The Federal Reserve has kept and is expected to keep interest rates at historic lows in order to jump start the economy and makes lending more attractive. Stock market fluctuations have many sharp spikes, both positively and negatively, and the emotional reaction of the market does not bode well for properly analyzing a stock. This begs the question of whether or not stock prices are currently reflecting all known and measurable information about a company. This also questions whether or not the current market is efficient.

There have also been studies performed that question the validity of whether GDP growth is in line with market returns, which is a part of some multi-stage version of the DCF model. Another issue with respect to the DCF is the fact that interest rates which are being kept artificially low, pushes stock prices higher, which skewing the results of the DCF. So in essence, the DCF does not currently accurately and reliably estimate investors required return – cost of common equity.

Similarly, CAPM estimates are distorted for similar reasons. Beta as a key component of the CAPM, measuring relative volatility or market risk. If the market data are being distorted because of artificially low interest rates, then beta may not be accurately measuring the relative volatility between an individual companies’ common stock return and the market return. This then suggests that the CAPM may also not be estimating investors required return accurately or reliably in current economic conditions and other factors may need to be considered along with beta. In addition, the current artificially low levels of interest rates is leading to an artificially low risk-free rate, no matter which U.S. Treasury security is used in the CAPM.  Because the CAPM is so dependent upon the risk-free rate, the current artificially low interest rate environment is thus leading to artificially low CAPM results. This then leads to the need to rely upon more cost of common equity models and a thorough evaluation of the data used for those models so that the results are not convoluted, because if they are, the appropriate ROE may not be allowed in a rate proceeding.

Based upon the current artificially suppressed interest rates, which are not allowed to flow freely with market sentiment, the results of DCF and CAPM are not consistent with what the equity market is suggesting. The economy appears to be doing well and the stock market looks to be doing even better, but the models that use market data don’t seem to be indicating that. The fact that the data are skewed and the DCF and CAPM model results are currently suppressed due to the artificially low interest rate environment leads to the conclusion that market and economic conditions are not being captured properly through these models. Therefore, rate of return analysts need to seriously and thoroughly look at, the market and the economy as a whole and their effects upon the inputs to these cost of common equity models and consider adding additional models to their analyses.