Tuesday, September 8, 2009

(Attempt at) Understanding the cost of equity

The first time I heard of the above mentioned term, laughter erupted in my head. Let me reintroduce myself. I am the 'cynic','mitch' and 'contrarian'. May be.

Going on; the only expenses that a firm bears towards its shareholders are the rewards that a shareholder receives.
Dividends, stock repurchases, stock price appreciation, rights issues (partial) - but most of all I believe it to be stock price appreciation.
The thing about the stock price, which quite a few people seem to forget, is that the weighing machine will eventually price in the company's performance.

Thinking of all this from a firm's perspective - I see 2 large expenses that it bears.
Dividend - something that the company would have retained in order to grow its size
And Stock repurchases - money spent to reduce outstanding shares, which in turn would -may be- reduce total dividend payouts.

My point is simple.
The cost of debt is simple to understand - in terms of coupon payments or in terms of default / risk probabilities.
The other thing about debt, it is usually a temporary source of capital unless you issue perpetual callable bonds or something like that.

Equity on the other hand is a PERMANENT source of capital.
In effect, even if the company performs poorly, let's say that it grows earnings at a very small rate YoY - even then there is nothing great that shareholders can do other than dump their shares and drive the stock price down.
Somewhere, it is important to understand that the stock price does not impact a company's performance - unless you link ESOPs or reputation and the like.

When market gurus say that the company's cost of equity is 9%, 15%, 21%
All that I can say is, HOW!!!???

I understand all the CAPM BS and the market risk premium goli but...
There is no actual cost that the company bears towards its equity.

It is however a very fine way of saying "equity returns exceed debt market returns!!"
"The weighted avg. cost of capital is derived through blah blah bluh bluh..."
"Future earnings that can be deliverable to shareholders should be discounted at the cost of equity!! :-| "

I wonder if I will survive in this conformist environment...

Had hinted through above mentioned, or may be posted somewhere else saying: There is no other definite way of measuring the cost of equity. The problem is humans always need answers and something such as finance cannot not be quantified. There is a need to plug holes. My contention is simple. If I have to discount a project undertaken by Google and a project undertaken by RIM; I believe they will have different costs of equity. If their Beta is the same, they will (providing for D/E ratios) end up with the same discounting factors. This does not make sense.
More Later

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