Part – 12
In this article we will learn about estimation of cost of equity
The cost of equity (Ke) is the rate of return expected by shareholders
Risk Free Rate
Risk free security has no default risk, no volatility and beta of zero. Practically such a security does not exist and hence, we use securities issued by political and stable government. Selecting the bond depends on the forecast horizon – short term or long term?
The closest approximation we have to the risk free rate is the yield on government bond. Most analyst use long term government bond yield. Ideally, the length of the forecast should be matched with the tenure of the bond used for calculation of bond yield. For example, if a company has been forecast-ed for 10 years, we should use 10 year bond yield as the risk free rate.
Overview of beta or What is beta?
Beta is a statistical measure of the variability of a company’s stock price in relation to the stock market overall. Beta is calculated by regressing the percentage change in a stock or portfolio against the percentage change in the market (usually as defined by an index like the SENSEX/NIFTY).
Thus, a beta of one (1) implies a stock that moves exactly with the market. Applying a beta of one (1) to CAPM would result in a premium over the risk-free rate equal to the average equity premium. A higher/lower beta means the stock is riskier/less risky and results in a greater/lesser required return. Most betas fall between 0.1 and 2.0 though negative and higher numbers are possible.
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Sensitivity of Beta is because of two has two components, the risk inherent in the assets of the business and the risk associated with the leverage applied to those assets.
Determinants of betas
- Product or service: The beta value for a firm depends upon the sensitivity of the demand for its products and services and of its costs to macroeconomic factors that affect the overall market
- Cyclical companies have higher betas than non-cyclical firms which sell more discretionary products will have higher betas than firms that sell less discretionary products
- Operating leverage: The greater the proportion of fixed costs in the cost structure of the business, the higher the beta
- Financial leverage: The more debt a firm takes on, the higher the beta will be of the equity in that business. Debt creates a fixed cost, interest expenses, that increases exposure to market risks
Unlevering and relevering beta
Beta is a statistical measure of the variability of a company’s stock price in relation to the stock market overall. However, if we are valuing a non-listed private company, we cannot find the beta as suggested above.
Below are the methodologies utilized by various sources in calculating betas:
Preferred beta methodology policy in India is that you should use Bloomberg provided Beta unless there is a good reason not to. However, for reference, the fundamentals of how beta is calculated are set out below.
Time horizon – five years
Studies have demonstrated that longer horizons give more accurate betas. Five years is considered an appropriate length of time to capture a stock’s movement while still reflecting current market dynamics. Shorter periods can reflect market or company aberrations more readily. Most major sources utilize this horizon.
Frequency – monthly
More history is available for monthly stock prices, allowing generally more in-depth studies. Weekly results can suffer from distortions which derive from the day of the week selected for closing prices. Daily results can be distorted by the Fisher effect, whereby end of day market movements are not matched with closing prices, as a closing price is recorded as the last trade, not necessarily a trade at the end of the day.
Adjustment – to tend towards one
It has been observed that as an industry/company matures, it acts more like the overall economy/market in general. Consequently, betas move more with the market over time. The raw beta will need adjustments to better reflect the tendency of betas over longer periods of time.
Use the index of the country in which your company is located. In India, SENSEX 30 should be used.
In this article we have learnt about estimation of cost of equity, we will find beta for private company…Till then, Happy Learning!
Here are some articles that will help you to get more detail about the CAPM Formula so just go through the link.