What Is Your Cost Of Equity?
Last year, I found myself thinking about the personification of risk. Am I more risk averse than I was a few years back? If so, why? I thought to myself: I am fresh out of the 30s gate, and there is a long road ahead to match the current Global or US life expectancy. Yet, I felt like something had changed. On a coffee run with a colleague, I made a comment about how my cost of equity has decreased. In a bid to make my musings relatable to matters we discussed frequently at work, I stumbled onto a concept that gnawed at me for the rest of the year. What is my cost of equity?
Cost of equity is the rate expected to be paid to compensate equity investors for their capital. The main formula is the Risk Free Rate + [Beta x Risk Premiums]. The Risk Free Rate is a rate that one theoretically believes comes with no string attached and can be achieved with very limited loss of value. The 10-year government bond yield is a great starting point. Beta is the sensitivity of the asset in question to the vagaries of the market. If the market goes up, will the asset be supercharged? If the market goes down, will the asset buffer your downside? Risk premiums include equity risk premium, political risk premium, and any other premiums one is keen to get compensated for in exchange for their money.
Now, to answer my question:
The current US 10-year government bond yield is 4.447%
For the question of Beta, I think of myself as an individual that is a little bit sensitive. While I am not a bungee jumping loving individual, I am also not a rocking chair aficionado. For example, Tesla’s beta is 2.41, compared to Nvidia’s 1.75 and Duke Energy’s 0.45. The market is 1. I would place myself at 1.5, subject to change as my year unfolds.
For the risk premium, I am going to answer a question posed by Professor Damodaran in my Corporate Finance class at Stern.
“Assume that stocks are the only risky assets and that you are offered two investment options: a riskless investment (say a government security) on which you can earn 3% and a mutual fund of all stocks on which returns are uncertain. How much of an expected return would you demand to shift your money from the riskless asset to the mutual fund? A) Less than 3%? B) Between 3-5%? C) Between 5-7% D) Between 7-9% E) Between 9-11% F) More than 11%”
Since the current US 10-year government yield is 4.447%, we can replace the choices with less than 4.5%, between 4.5-6.5%, between 6.5-8.5%, between 8.5-10.5%, between 10.5-12.5% and more than 12.5%. For me, it would be between 8.5-10.5%. Using a midpoint approach, I would demand an expected return of 9.5% to shift my money to the mutual fund. As a result, my risk premium is 5.05%, my expected return minus the risk free rate.
Seun’s cost of equity = 4.447% + 1.5 x (5.05%) = 12.05%
Well, what does this all mean? If I am assessing an action that involves an exchange of my capital, 12.05% is the threshold that would make the exchange worth it. Nevertheless, this can be a useful exercise to contemplate risk and yourself.
