By Leslie Harrison
For an accurate and actionable cost of capital, advisors integrate various factors, such as economic trends, industry dynamics, and/or company-specific factors.
It’s probably as obvious as the sky is blue that if an investor wants to earn higher returns, he/she will have to accept higher risks. Less obvious, perhaps, is the origin of this concept known as the ‘risk-return trade-off.’
Historical data shows that while government bonds have long been among the safest assets, they have also consistently delivered some of the lowest returns: over the past decade (2015-2024), U.S. Treasury bills yielded a return of just 1.8% with a risk of 0.6% (measured by standard deviation), whereas U.S. corporate high-yield bonds delivered a more appealing return of 5.1% albeit with a risk of 7.6%. Investors seeking even greater returns would have had to consider more volatile assets, such as equities: the S&P 500 delivered a return of 10.7% with a risk of 15.9% over the same period.
Exhibit
An analysis of historical data, like the one above, illustrates the positive relationship between risk and return. In fact, this correlation holds true when reviewing risk-return data from the present day all the way back to the 1930s, and it is this persistent correlation that underpins the concept of the risk-return trade-off.
Over the short term, however, certain assets may occasionally exhibit disproportionally high returns relative to its risks, but such assets cannot exist over the long run as investors would continuously purchase the cheap asset, bidding up its price and driving down its return.
The risk-return relationship implies that investors should demand additional return to compensate for taking on additional risks. This compensation to investors, known as the risk premium, is a building block in the calculation of the expected return of an asset (also called the cost of capital or the discount rate).
Deconstructing the components
The cost of capital boils down to two essential components: the time value of money and risk assessment. The time value of money reflects the idea that a dollar today has greater utility than a dollar in the future. Risk assessment, on the other hand, addresses the uncertainty of future cash flows.
In the context of corporate valuation, a common metric for the cost of capital is the Weighted Average Cost of Capital (WACC). WACC represents the blended cost of financing proportionally weighted based on the company’s ideal capital structure. In its simplest form, WACC consists of two components: the cost of equity and the cost of debt. The cost of equity reflects the return required by equity investors for the risk of holding equity in the company. The cost of debt reflects the interest rate charged by lenders for providing capital to the company.
Where:
The cost of debt should ideally reflect the current interest rate at which the company could borrow in the current market—rather than the rate tied to existing debt instruments. While a company’s current borrowing rate may sometimes be a reasonable proxy, market conditions, credit risk, and other factors can make it necessary to estimate a more forward-looking rate.
It’s also worth noting that WACC is not necessarily static. Some analysts and appraisers adjust the capital structure weights or even the cost of equity and cost of debt components over time to reflect anticipated changes in financing strategy or business risk profile While such adjustments can introduce complexity—and some debate—they may be warranted in scenarios where capital structure is expected to evolve materially, such as in the case of startups or of rapidly growing companies.
Calculating cost of equity
The cost of equity can be estimated through various methods, each suited to different valuation scenarios. Below are a few common methods:
- Capital Asset Pricing Model (CAPM): CAPM is a popular method for estimating the cost of equity by linking expected returns to market risk (beta) and the risk-free rate. It is commonly used for publicly traded companies with readily available market data. The method is a relatively simple model that calculates returns based only on the asset’s systemic risk.
- Build-Up Method: As the name implies, this method calculates the cost of equity by starting with the risk-free rate and adds premiums to account for various risks, such as industry risk, country risk, and company-specific risk. The build-up method is particularly useful for small or private businesses that lack robust market data. While intuitive, the method relies heavily on the appraiser's judgement and assumptions.
- Dividend Discount Model (DDM): DDM is primarily used for companies that pay regular dividends. It estimates the cost of equity by dividing the expected annual dividend by the stock price, adding the expected dividend growth rate. This method is particularly effective for mature companies with a consistent history of dividend payments.
- Arbitrage Pricing Theory (APT): APT is a more advanced model that allows for multiple factors influencing the return on equity. Unlike CAPM, which uses a single factor (i.e., beta), APT takes into account several systematic risk factors that may affect the cost of equity. These could include interest rates, inflation, and other macroeconomic variables. While it requires more data and calculation, APT is a useful model for companies operating in diverse or unpredictable environments.
Each of these methods provides a different angle for estimating the cost of equity. The choice of which method to use depends on the available data and the characteristics of the company or asset being valued.
Professional judgement remains essential in ensuring the calculated cost of capital reasonably aligns with comparable assets and with the company’s historical performance and future prospects.
The value of professional expertise
An accurate cost of capital is essential to reliable valuations. Misjudging risk profiles can distort valuation assessments, resulting in suboptimal business decisions or indefensible appraisals. Professional advisors bring distinct advantages:
- Technical rigor and objectivity: Application of established methodologies and impartial analyses to ensure reliable outcomes.
- Access to comprehensive data: Utilization of extensive proprietary databases, industry benchmarks, and analytical tools.
- Tailored solutions: Customization of discount rates ensures that valuations align with the specific characteristics and valuation contexts.
- Enhanced stakeholder confidence: Valuations performed by qualified experts confer credibility in negotiations, regulatory submissions, and legal disputes.
By engaging professional advisors, stakeholders gain access to specialized expertise that enhances decision quality. Whether for M&A transactions, investment analysis, financial reporting, or litigation support, carefully determined cost of capital enhances confidence and clarity, ensuring sound financial decisions that align with broader objectives.