Mail Bag: Cost of Equity in the Capital Asset Pricing Model

Eight months ago, a comment was left on a post that I never saw.  It was also left without a Disqus profile, meaning no email notification to the original poster.  It was such a good question, that I thought it deserved and answer and I am putting it here, as a mailbag, in the hopes he sees it.

Hi Joshua,

I know that feeling of having so much to do you don’t even want to start. Sometimes it helps me to choose one thing and make it a point to have it done by the end of the day. Of course I make sure it’s an important task or project.

I wanted to ask you a question about valuation. I’ve read that you think beta is worthless, so it’s reasonable to assume you don’t use CAPM either. How do you establish the cost of equity or required return then? Do you use your experience and judgement?

Mario

Before I get to the cost of equity under the CAPM, let me explain how I approach the task of valuing an asset.

When I calculate intrinsic value for anything – people too often think of stocks, but it is true for everything from an apartment building to a car dealership – I look at the adjusted net cash flows (e.g., backing out weird depreciation things if there are some unusual situations, analyzing inventory levels, such as if there is some sort of artificially low inventory cost basis that is inflating profits that can’t be maintained in the future, etc.), and then discount those cash flows back to the present.  Things like cost of debt capital are very important because they influence that net cash flow figure – if you could buy a business paying 10% on its liabilities and use your financial strength to get that down to 4%, you can pay a higher price because you can instantly make intrinsic value higher than it is for other investors.

As for the discount rate, I tend to use the risk-free Treasury plus a modification for inflation. That way, everything is discounted at the same rate. That may sound odd at first, but it serves as a conservative check against human nature: Too often, investors will compensate for not being able to accurately project cash flows in high risk situations by substituting an arbitrarily high discount rate. While it can make sense in certain situations (e.g., a private equity investment in a Silicon Valley startup), it provides a false sense of security in many situations. If I can’t project the cash flows, it forces me to accept that I am speculating, not investing.  If I am not comfortable discounting at the lower rate, I throw the potential holding off the pile and move on to something else.  If I wanted excitement, I’d go to Vegas.  I want to get richer.

That way, all potential investments – stocks, bonds, real estate, expansion at the private businesses, or anything else that generates cash – are ranked against each other. I’ve said it elsewhere on the site, but if we were suddenly in a situation where stocks were highly unattractive, and I were offered the local McDonald’s franchises at a rate 2x higher than any other alternative use of cash, and that it beat inflation and taxes handily in my analysis, I’d acquire it.  I’d be sitting here with a McDonald’s cap on and, probably given my personality, be serving coffee to customers when I felt like getting out of the office because I love seeing businesses work.

In other words, I value things, look down the list, and if something is attractive, it gets bought.  My selection is colored by my personality, as are all portfolios; I prefer businesses that grow themselves and never need to be sold.  Give me one of those at an attractive price and I am a happy, happy man.

This approach lets me use an apples-to-apples comparison.  It treats $1 of net cash as $1 of net cash, regardless of if it comes from a sewage treatment plant or an exciting technology project.  It also makes me explicitly acknowledge errors in my model when and if they occur, causing it to get better over time.  

That said, to your question: The cost of equity capital under the CAPM model.  It is idiotic.  Completely and totally idiotic.  If I buy a storage unit business, and hold it directly through a limited liability company, there is no quoted market fluctuation in the asset.  The discounted cash flow analysis would not change.  Were I to suddenly issue shares, and have a quoted market for them, underlying reality for the business is no different, so the net present value remains the same but the CAPM model introduces a valuation variable based on what those shares do as some sort of imperfect proxy for the performance of the underlying business and perceptions of outside investors.  How wildly the stock price fluctuates has no influence on how much cash I can take from the properties as the control investor.  

It has no value to what I consider important: It’s the cash that matters.  I want to buy the most cash, at the lowest price, adjusting for growth and factoring in inflation and taxes.  CAPM’s cost of equity formula does nothing to help me achieve that end because the inclusion of the beta variable as a component is effectively meaningless.  It can be measured, but it doesn’t tell you much about what counts: How much cash, can I, as the control investor, take out of the enterprise?

Other than stock options, I have never used Beta, one of the components of calculating the cost of equity under CAPM, to make a single investing decision.  It implicitly presumes that other people are acting rationally and solely in terms of the prospects of the underlying security, which is not always the case.  In some situations, people are forced to sell (e.g., the non-economic selling of 2009) to raise liquidity, even though they know the assets they held are cheap.  Do you think people wanted to get rid of their American Express stock so that it was trading at $10 per share?  Or their Wells Fargo so that it was below $10 per share?  Sure, there were some panic sellers in there, but a lot of institutions were raising money because scared investors were forcing redemption or cash needed to be raised for emergency management.  These managers had no choice.  The CAPM can’t use human judgment because it doesn’t factor in those extenuating circumstances.

Formulas are good, but over reliance on models has now created three major capital market collapses in the past 30 years.  You cannot stop thinking and using your judgment.  In my opinion, the cost of equity under CAPM does just that.  It makes no sense.

(As a side note: Sometimes, the term “cost of equity” is used to describe another calculation outside of the capital asset pricing model.  It involves taking the dividends per share and dividing by the current market value of the stock, then summing the result with the growth rate of the dividends per share.  The purpose is to show you the theoretical return investors are demanding for owning a business at any given time.  It can be interesting to use.  I have no qualms with that metric.)