Determining the cost of equity

Transcription

1 Determining the cost of equity Macroeconomic factors and the discount rate Baring Asset Management Limited 155 Bishopsgate London EC2M 3XY Tel: +44 (0) Fax: +44 (0) Authorised and Regulated by the Financial Conduct Authority April 2016 FOR INSTITUTIONAL INVESTORS / PROFESSIONAL ADVISERS ONLY

2 Executive Summary Cost of equity (COE) is the minimum rate of return demanded by equity investors for committed capital. Since the cost of capital varies from market to market, and is dependent on economic and monetary conditions, the cost of equity varies too. Determining this can be challenging, introducing complexities and issues of consistency between investment desks. One way of dealing with the challenge is to follow a standardised approach. Having reviewed a number of different alternatives, we have decided that it is appropriate to take the Capital Asset Pricing Model (CAPM) as a guideline, and to centralise the inputs for risk-free rates as well as market equity risk premiums. Our approach allows us to determine a COE (or discount rate used to value companies) across markets, making it possible to perform comparisons between companies in different markets. In addition, the approach we describe in this paper makes full use of the company-specific expertise of our equity analysts. Our investment horizon for forecasting company earnings is five years, and we wanted a discount rate that matches this time horizon and is not determined by the market. To that effect, we use five-year IMF inflation forecasts in the calculation. This allows us to draw on a well-established and reliable data series, something that is not always available in emerging or frontier markets. As we take an unusually long time horizon of 5 years ourselves when analysing companies, we believe these data series are appropriate. Our approach has the advantage of simplicity, making it straightforward to adjust for specific macroeconomic events in a timely fashion until expectations catch up. While there are clearly some issues around using a centralised methodology across very different markets, we believe the flexibility of this approach and the ability to compare companies in different markets easily, in a way which accounts for macroeconomic risk, is a powerful advantage. This paper sets out some of the thinking behind our decision. It is not a research paper, and it is not intended to provide a detailed mathematical proof. It is, however, provided as a service to our clients, and we hope that it proves valuable. Dr. Ghadir Abu Leil-Cooper Head, EMEA & Global Frontier Markets Equity Team Baring Asset Management, London April

3 Cost of equity and the Capital Asset Pricing Model In finance, the cost of equity is the minimum rate of return demanded by equity investors to compensate them for the risk of owning the company compared to another investment they may otherwise make. While the cost of debt is relatively easy to determine from the observation of interest rates in the capital markets, the cost of equity is not observable, and must be estimated. There are competing theories around how best to do this. For our purposes, the cost of equity can be approximated by the Capital Asset Pricing Model (CAPM). The formula for this is as follows. Cost of Equity = Risk-free rate + (Company s Beta x Equity Risk Premium). In order to take into account the macroeconomic conditions companies operate in, and in a bid to combine the discount rate (cost of equity) with the period we forecast earnings for, we have decided to use centralised inputs. These are as follows. Risk free rate 1. We use the IMF data series for inflation as a starting point. It is the best and most complete data series we have which is directly comparable ( 2. We take the IMF s inflation compounded annual growth rate (CAGR) for the next five years for the market where the company operates. 3. To determine the risk free rate, we decided to add 2.25%. That s the average difference between the 10-year bond yield and inflation in the US since Equity risk premium 4. We continue to draw on the quality and length of data available in the US when establishing the equity risk premium. 5. At different times, different markets have demanded different risk premiums, but it is the longest series we have. In our approach, developed markets are discounted at 4%, emerging and frontier markets at 5%. Company beta 6. Finally, rather than using market data to calculate beta, our analysts will assess company specific risk, in a range of 0% to 2%, and environmental, social and governance (ESG) factors, in a range of -1% to +2%, for that part of the equation. It is worth noting that the result of this is a discount rate that reflects only the cost of equity, in other words, as if the business is financed solely through equity. This is intentional. This is quite different from the weighted average cost of capital, which analysts tend to use for discounted cashflow calculations. 2

4 (i) The Risk-free rate Looking at the different parts of our equation in more detail, the risk-free rate is usually what a bond investor demands to be compensated for holding a bond. This has to take account of inflation and allow for a real positive return. For our purposes, the risk-free rate be can determined as follows. Risk-free rate = IMF local inflation forecast 5y CAGR % We have decided to use inflation as our starting point rather than, for example, government bonds, to avoid being unduly affected by short-term term pricing in the bond market, and to determine a rate that can be used over the full investment cycle. Figure 1: US CPI and 10-year rates over the very long term Source: Baring Asset Management, June Since 1871, which is the longest time series available, the average difference between bond yields and inflation has been 2.36%.. However, as you can see, the early parts of the data series are volatile and less relevant. Our preference instead is to use the average difference between 1949 and now, which is 2.25%. 3

5 (ii) The Equity Risk Premium The second part of our calculation involves looking at the equity risk premium. Equity Risk Premium = 4% for developed markets, 5% for emerging markets It is not possible to determine an exact number for the equity risk premium, and not all markets would have the same outcome if you examine historic data. We are using data from the US again, as this market has the longest available history. For example, the equity risk premium for the US has varied through history, and has recently come down. However, as we are taking a long-term series, we believe that 4% is appropriate for developed d markets, and 5% for emerging and frontier. This is supported by empirical evidence from data showing what markets demanded for return on equity over long periods. Figure 2: Calculation of the equity risk premium for the US S&P 500 3m T-Bills 10y US Bonds ERP v ERP v CASH BONDS % 3.488% 4.999% 6.109% 4.598% % 4.325% 8.157% 6.505% 2.673% % 2.721% 6.286% 6.943% 3.378% % 2.331% 5.311% 5.703% 2.723% Source: Barings and Damodaran, as at September Please note that the average calculation is based on a geometric average. 4

6 Exceptions to the above calculations IMF inflation There are always periods of stress when the data does not predict what you expect. Discount rates calculated using the previous method for emerging markets may predict lower than developed market discount rates or between markets. This is often down to deflation, or a lack of inflation. We have, therefore, allowed an override to account for this. One such example is the case of Italy versus Germany, where lower forecast CPI for Italy imply the risk free rate for Italy is lower than Germany, which we believe is not appropriate. Therefore, we can adjust for it by using one European rate. Furthermore, in exceptional market conditions we will review our discount rate and may add to the equity risk premium in times of market dislocation. In particular, when the market is at risk of default, or when politics are emerging as a risk factor, we can add up to 5% to the equity risk premium. We saw this in Greece, Russia and Brazil in 2014/15. We make these adjustments to reflect macroeconomic breakdowns. This allows us to adjust for any such dislocations quickly, before analyst and inflation expectations catch-up. (iii) The Company s Beta (β) For the purposes of the Capital Asset Pricing Model, we define the company s beta as follows. Company s Beta (β) = company specific risk, in a range of 0% to 2% + ESG factors, in a range of -1% to +2% In effect, this adjusts the equity risk premium between the range -1% to +4%. Although the formula for the Capital Asset Pricing Model uses the beta of the company multiplied by the equity risk premium, this can be mathematically approximated by adding company specific risk to the equity risk premium. Most companies have a β of between 0.8 and 2.0 to their market, depending on the volatility of the share. This usually reflects the volatility of the business model and financial structure. A β of 0.8 is mathematically equivalent to subtracting 1 from the equity risk premium, while a β of 2.0 is equivalent to adding 5 to the equity risk premium. As most quality companies have a β of less than 2.0, adding between -1% and 4% (to allow for company specific risk and ESG factors) can therefore be said to be mathematically equivalent to multiplying the β by the equity risk premium. As the same company will have different β to different market indices, our preference is to define it in this way for greater consistency and to ensure that appropriate risks are accounted for. Company specific risk, therefore, allows our analysts to reflect the volatility of the business model and financial and balance sheet structure. Including company specific risk and ESG factors in the calculation rather than beta allows us to accommodate different companies in the same market with very different company specific risks. For example, banks are more regulatory sensitive and cyclical so have a higher degree of specific risk than consumer companies or breweries. Similarly, companies with stronger balance sheets should be discounted less than more leveraged companies. 5

7 Conclusion Bringing everything together, the equation we use for the cost of equity, or discount rate when valuing companies, is as follows. Cost of Equity (Discount rate) = Risk Free Rate + Equity Risk Premium + Company Specific Risk + ESG While the framework we have come up with for calculating the cost of equity is not perfect, it has the advantage of allowing us to compare companies within the same market or across different markets. It is easy to adapt, is flexible, and utilises centralised data and analyst expertise rather than volatile market data. Above all, by incorporating these calculations, it allows our portfolio managers to focus on optimising portfolios, since price targets are already reflective of macroeconomic risk. Dr. Ghadir Abu Leil-Cooper Head, EMEA & Global Frontier Markets Equity Team Baring Asset Management, London April

8 IMPORTANT INFORMATION For Professional Investors/Advisers only. It should not be distributed to or relied on by Retail Investors. This document must not be relied on by any other category of recipient. This document is issued by Baring Asset Management Limited, authorised and regulated by the Financial Conduct Authority and in jurisdictions other than the UK it is provided by the appropriate Baring Asset Management company/affiliate whose name(s) and contact details are specified herein. This is not an offer to sell or an invitation to apply for any product or service of Baring Asset Management and is by way of information only. The information in this document does not constitute investment, tax, legal or other advice or recommendation. This document may include forward looking statements which are based on our current opinions, expectations and projections. We undertake no obligation to update or revise any forward looking statements. Actual results could differ materially from those anticipated in the forward looking statements. We reasonably believe that the information contained herein from 3rd party sources, as quoted, is accurate as at the date of publication. This document must not be relied on for purposes of any investment decisions. Version12/SD Baring Asset Management Limited 155 Bishopsgate, London, EC2M 3XY Authorised & Regulated by the Financial Conduct Authority Complied (London): 15 April Ref: M04/29 7