I recently wrote an article on the Art and Science of Valuation.
There’s several components to it so I wanted to break down how to calculate a company’s Cost of Equity. Why would you want to know Cost of Equity? Because the cost of equity is used to discount a company’s future cash flow into today’s dollars.
Financial Analysts use the Capital Asset Pricing Model (CAPM) to determine the components of a company’s cost of capital. As equity investors we are interested in the company’s Cost of Equity.
There are three components to determining Cost of Equity:
1. Risk Free Rate
3. Market risk Premium
Risk Free Rate
The risk free rate is usually a government issued debt rate that is basically a proxy for the long term rate of inflation. I like to use longer dated (10-30 year) treasuries to match my investing time horizon. Additionally it is slightly less susceptible to manipulation by Central Banks. At the moment the 30 year treasury rate is 1.2%
Beta is a measure of price volatility. You can typically find this in any finance website. It will vary somewhat because of different time periods being measured, but they should be close.
As an example, $T’s beta is 0.94
Market Risk Premium
This is the amount of return we’d be expected to get by investing in the stock market vs bonds. There are some research firms that try to maintain this number. Duff & Phelps is one example. According to them historically the premium has been about 5-6%, with a current premium of 6%.
Putting it All Together
Now we have the components so here is the equation
Expected Return = Risk Free Rate + (Beta * Risk Premium)
Let’s use trust AT&T as our example.
Risk Free Rate = 1.2%
Beta = 0.94
Risk Premium = 6%
Expected Return = 1.2% + 0.94 x 6%
So with our first pass $T’s expected return is 6.84%.
Immediately I’d think this is very low and my thoughts would jump to the treasury rate being only 1.2%. As an analyst I’d likely bump that up to at least 2% and maybe 3% pushing the expected return to 7.64% – 8.64%. This seems more likely to adjust for Fed intervention in the treasury markets.
With AT&T’s dividend yield at 6.89%, you’ll find that there isn’t a lot of room for capital appreciation. However, as income investors we can sit a little easy knowing that we can collect a nearly 7% return in a very low risk stock.
So that’s that! We’ve calculated an expected rate of return for money twitter’s favorite dividend stock!
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