Question of the Month
30 November 2011
Question: I wonder if 10% is too high an estimate of the cost of equity, given the current low interest rate environment?
A VERY interesting question. This is what we think…
You usually estimate cost of equity using the capital asset pricing model – ie risk free rate + equity risk premium (adjusted for beta).
Currently, risk free rates look very low. Therefore if nothing else has changed, you’d argue that the cost of equity should be much lower now than it was a few years ago.
However… these very low interest rates in most countries are mainly the result of the on-going financial turmoil caused by the credit crunch, Eurozone debt crisis and problems with passing the US budget cuts. This may be part of a long term trend, but you could argue that it’s really (temporary) market dislocation. If that is the case, then it may not be appropriate to use the very low current risk free rate – maybe we should be looking further up the yield curve?
Second point… if risk free rates fall but the equity risk premium remains unchanged, this means cost of equity should have fallen (and therefore the discount rate for valuation has fallen) and so equity prices should have risen sharply… which they haven’t.
So the other possible explanation is that while the risk free rate has fallen, the equity risk premium has increased sharply. This would figure because we know that investors don’t like risk assets currently (judging by the rise in the gold price etc).
So overall, we think the market is still using a cost of equity of 10% or maybe even higher. Clearly some companies agree with us - both HSBC and Barclays for example have both been using cost of equity of over 10% for their economic profit calculations during the last couple of years.