Superb businesses
Raising cheaper equity
We are all looking to invest in superb companies. The big question is how to identify them. It’s easy enough to say they should have nice big economic moats. But how to identify the moat? A good place to start is by looking at the numbers. We are looking for a company that is capable of earning excess returns on capital for a long period of time.
I say a good place to start, because the numbers don’t tell the whole story. They are tools. As Warren Buffett warns us in his 1986 Chairman’s letter: “…accounting is but an aid to business thinking, never a substitute for it.”
Ultimately the assessment of a company’s moat is a matter of business analysis. It is as much subjective as it is numbers based.
High excess ROIC
Anyway, let’s take a look at how we approach the numbers. The first step is to look for companies that produce a high Return on Invested Capital (ROIC) number. This is often calculated for investors by analysts. There are many problems with the calculation. See for example my post Problems with the most popular indicator of superb companies
Next we need to figure out the ‘excess’. To get this number you subtract a company’s cost of capital from its ROIC. A company’s cost of capital is made up of its cost of debt and its cost of equity. The notion behind this is that both debt and equity capital have a cost to a company. If the company needs more capital, it can borrow and hence incur debt. The cost of a company’s debt is easy enough to determine. If the company has issued bonds these are detailed in the annual report. If there is bank debt, the interest charged by the bank will give us a number. Putting the cost of debt capital and the cost of equity capital together gives you a Weighted Average Cost of Capital (WACC)
The main problem here is coming up with a company’s cost of equity capital. That is the focus of today’s post.
Cost of Equity Capital
The conventional (i.e. used by almost all stock analysts today) calculation of the company’s cost of equity capital requires a formula to produce the risk-weighted rate of return required by equity investors in the company. In essence, the conventional formula captures the idea that the cost of equity equals the risk-free rate of return plus a premium expected for risk. It will be immediately apparent to many readers that this is the same concept as the Equity Risk Premium discussed in other posts.
It also an investing concept that the Capital Asset Pricing Model (CAPM) has messed up for generations of investors.
CAPM missteps
When a company’s stock is more volatile than the average stock in the S&P 500, the conventional finance theory view, based on the Capital Asset Pricing Model (CAPM), is that a company’s cost of equity is higher since the stock is considered riskier and thus raising equity would be more expensive. This is fundamentally flawed; volatility is not a valid proxy for risk. The approach causes the cost of equity capital to be calculated at more than it should be for some companies and less for others. It can perversely show a very high cost of capital for a company with a pristine balance sheet and solid sustainable earnings whose stock just happens to be volatile. It could borrow at cheap rates and if it did borrow, its cost of debt as part of the WACC would bring the total WACC down significantly. But if its stock price is volatile its WACC can be quite high. An old buggy whip company playing out the string may be a very low volatility stock but it may be a high-risk investment with a low Price/Earnings ratio and its cost of equity capital should be correspondingly high.
Can we replace CAPM in calculations of cost of equity capital?
My own humble thoughts. A disclaimer: I am not a professional stock analyst, just an investor.
If the CAPM is flawed, what can replace it? The best approach would be to assess whether companies in general and relatively speaking, the company in question, can raise money cheaply in public offerings. When shares are trading on the stock exchange at ridiculously high Price/Earnings ratios, one could say the Cost of Equity is generally cheap. If our company is trading at a higher price to earnings ratio than the S&P 500 average, it would be raising equity cheaper than the market as a whole, i.e. its Cost of Equity would be lower.
Earnings yields and cost of capital
If S&P 500 trades at a trailing twelve-month (TTM) Price/Earnings ratio of 20 i.e., an earnings yield of 5%, and the stock of company A trades at a Price/Earnings ratio of 25, i.e. an earnings yield of 4%, the stock of company A is trading at an earnings yield 1% lower than index. If, for our example, we take the current Equity Risk Premium to be about 4.33% (See The price of risk in equity markets) and a normalized risk-free rate to be 4%, we can say that company A with a Price/Earnings ratio of 25 has a cost of equity capital of:
Risk free rate 4.00%
S&P 550 recent Equity Risk Premium 4.33%
Less Earnings yield discount -1.00%
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Cost of equity capital 7.33%
Such a company might borrow on a debt basis at say, 3% to 5% above risk free rate, i.e. at 7% to 9%. Based on the company’s debt equity ratio is would be easy enough to calculate its weighted average cost of capital (WACC).
Company B with a Price/Earnings ratio of 15 has an earnings yield of 6.67%. At a time when the S&P 500 index has a Price/Earnings ratio of 20 and an earnings yield of 5%, company B trades with an earnings yield of 1.67% higher than the S&P 500 index. It is obvious that company B has a cost of equity capital more expensive than the S&P 500 index. Its cost of capital might be thought of as:
Risk free rate 4.00%
S&P 550 recent Equity Risk Premium 4.33%
Plus earnings yield premium 1.67%
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Cost of equity capital 9.33%
Compared with CAPM approach
It is the writer’s experience that most calculations of the weighted cost of capital using the CAPM seem to generate an excessive cost of equity.
Using CAPM, in current conditions in both debt and equity markets, companies with substantial equity capital tends to have a higher WACC than companies with much lower equity capital. This tends to give many indebted companies higher ROIC than they deserve and many companies with pristine balance sheets less ROIC than they deserve. As well, using the CAPM it is almost impossible for a company to have a cost of equity less than the S&P 500, which is plainly wrong.
The problem with using earnings yields
Unfortunately, the use of Earnings Yields is also problematic. In the modern age of companies with mostly intangible assets and major investments in intangibles of lasting value, the reported earnings of companies are also distorted. See my post The forward earnings yield another obsolete indicator
Ultimately, analysts will come up with some formula that captures a company’s unique cost of raising equity capital.
Conclusion
Most analysts would agree that using numbers to come up with some indication of a company’s economic moat is a good idea. The numbers calculated by analysts are useful. However, investors have to understand the formula that is used. The ROIC number can be roughly modified or adjusted. It is always useful to ask oneself if the numbers make sense. Often, they don’t! In the case of some great companies trading at high price earnings ratios whose stock prices are quite volatile, the analyst’s calculations of their Cost of Equity can be way off base.
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For readers wishing to dig into the use of ROIC as an indicator of superb companies check out these posts:
The awkward link between Buffett’s moats and ROIC
Buffet moats and the secret sauce of pricing power
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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