Education: Value Investing

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Discount Rate Calculation

We cannot emphasize enough how important the choice of what discount rate to use is when conducting a discounted cash flow analysis. Since the discount rate is such an important calculation, we have dedicated an entire education piece to it. Well, look no further…

Cost of Equity Defined

In order to arrive at your discount rate, one of the underlying components of the calculation is the cost of equity. Cost of equity can be defined as the rate of return required by a company's common stockholders. If shareholders do not receive the return that they expect out of their investment, they may be inclined to sell their shares. Thus, a company will have to make sure it returns what its investors desire, through share appreciation and dividends.

While a number of different cost of equity models are currently employed by valuation professionals, they usually have three components in common: risk-free rate, beta and equity risk premium.

Risk-free Rate

This number typically corresponds to what an investor expects to receive from investing in a security with zero risk. While even the safest investment vehicles, such as U.S. Government bonds, cannot be truly risk-free, they are the closest thing. The portion of a U.S. Government bond that is virtually riskless is its yield. Thus, most use the yield on a long-term U.S. Government bond as their risk-free rate.

Beta or Industry Risk Premium

This figure attempts to quantify a company’s risk relative to the overall market, typically represented by the S&P 500. A company with a beta greater than one is riskier than the market, while one with a beta less than one contains less risk.

Similarly, a company that participates in an industry that has a positive risk premium is riskier than the market, while an industry with a negative risk premium contains less risk.

Equity Risk Premium

This may be the most debated underlying figure used in a cost of equity calculation. From a 10,000 foot view, it can be defined as the expected return on stocks over bonds. Since stock investors are taking on more risk versus those investing in bonds or risk-free assets, they want to be compensated accordingly. The equity risk premium has been calculated using a variety of different approaches.

Cost of Equity Formulas

Now that we gave you the ingredients for your cost of equity calculation, you probably need a formula to plug those into. There are two commonly-accepted methods for calculating the cost of equity: Capital Asset Pricing Model (CAPM) and the Buildup Method.

CAPM

A gentleman by the name of William Sharpe, a financial economist and Nobel laureate in economics, invented the CAPM where the cost of equity equals:

Risk-free rate + (beta x equity risk premium)

Buildup Method

Ibbotson Associates is generally credited with developing the buildup method. In this model, the cost of equity equals:

Risk-free rate + equity risk premium + size premium + industry risk premium

While we haven’t covered the size premium, and briefly touched on the industry risk premium, we will leave those to the experts and suggest you look into purchasing one of Ibbotson’s publications for the data and for more information.

Cost of Debt

As we saw above, the cost of equity can be a tricky little calculation. Luckily, the cost of debt is a little more straightforward. This number typically corresponds to the interest rate a company is paying on all of its debt, such as loans and bonds. Companies of higher risk will usually have a higher cost of debt.

Capital Structure

When you break up how a company is financing it business operations—either by issuing stocks or by selling bonds—this can be referred to as its capital structure. This is also known as a company’s debt-to-equity ratio. Is a company more heavily financed by debt or by equity? These will obviously sum to 100%.

The Grand Finale

I am sure your head is spinning at this point so let me conclude with an example. Hopefully this will help solidify the discount rate calculation. We will calculate the discount rate for Kruger Industrial Smoothing (fictitious company).

Cost of equity: 12%

Cost of debt: 6%

Equity capital: 60%

Debt capital 40%

The weighted average cost of capital (WACC) puts together your cost of equity and cost of debt calculations, while utilizing the company’s capital structure. Kruger Industrial Smoothing’s WACC is calculated as follows:

(60% x 12%) + (40% x 6%) = 9.6%

And there you have it—9.6% is the discount rate to be used in your discounted cash flow analysis.