Any asset can be valued by discounting its future cash flow via a discount rate. This discount rate is called the weighted average cost of capital.
Most finance professionals have been taught to calculate the cost of equity using the Capital Asset Pricing Model (CAPM) and the cost of debt as a risk-free rate plus a credit spread.
Cost of equity = Risk-Free Rate + Beta X Market Risk Premium
Cost of debt = Risk-Free Rate + Credit spread
Terminal value = Free cash flow / (Cost of capital – growth)
Let’s assume free cash flow is 1000 and growth at 4% and see the difference.
Terminal value = 1000 / (8.5%-4%) = 22,222
Or
Terminal value = 1000 / (9%-4%) = 20,000
A difference of 2,222 can be huge, depending on the context.
We can see that relying on the capital asset pricing model is not wise. Rather than a precise number, even our ballpark number is good enough.
“Cost of capital is what could be produced by our 2nd best idea, and our best idea has to beat it.” – Warren Buffet
In the Indian context, our second-best alternative to equity is government security. However, we want to find out the cost of capital within the Equity group.
There are more than 6000 companies listed on NSE. However, all the companies are not the same.
“Think of three types of ‘savings accounts.’ The great one pays an extraordinarily high-interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will also be earned on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.” – Warren Buffet
Great business: High Return, High Growth
Example: Asian Paints, Nestle India
These businesses have a predictable cash flow. The risk attached to the cash flow is minimal.
Good business: High Return, Low Growth
Example: HDFC bank, HCL tech
These are good businesses, but cash flow growth is less predictable.
Gruesome business: Low Return, Low Growth
Example: Airtel, DLF
When you are investing your money, you should focus your efforts only on great and good businesses. Instead of using a capital asset pricing model, we can use a range-based cost of capital.
1. Equity returns: Since the weighted average cost of capital is a form of expected return, an easy way is to find out what has been the average expected return. The return would vary from the lowest category of risk to the highest category of risk. Please note that our definition of risk is only linked to the loss of capital and not to volatility.
A 10-year government bond security yield is around 7.5%, a large cap return is around 10%, a MidCap around 13% and a small cap around 15%. Even the most predictable cash flow-based equity will have some premium over a 10-year government bond yield so we can assign 7.5% +1.5% = 9%. So, the broad range is between 9 to 15%.
Depending upon the predictability of cash flow, you can assign the cost of equity. A feature of great business would be predictable cash flow, hence a lower cost of equity. Similarly, a good business with a less predictable cash flow may require a higher range of cost of equity.
2. Dividend-based approach: this is another approach to understanding the cost of equity. In simple terms, it is the dividend growth rate plus the expected GDP growth rate plus inflation.
An average dividend yield is around 1.5% plus the expected GDP growth of India is 6% plus the higher end of the inflation band which is 6% so the total is 13.5%.
Now the company may have an expected return growth rate of more or less than the GDP. For example, Colgate will have a lower GDP growth rate than India's GDP whereas CDSL may have a little higher GDP growth rate.
Another variation could be companies deriving their revenue from global markets. For example, the TCS growth rate can be associated with the global GDP growth rate. So, the adjustment should be done using the global GDP growth rate of around 3%. And in the global context the expected inflation is also less that is around two or 3%.
The capital structure may include debt as well. You can look at the recent borrowing by the company and use that as a proxy for the cost of debt. Apply relevant weights based on the capital structure and accordingly come out with the cost of capital.
It is better to be roughly right than precisely wrong. This is the reason using a range of cost of capital and applying that range to the company’s Cash flow is a better approach than using the capital asset pricing model.
When you are valuing a good or great company, one of the indicators of a good or a great company is a high return on invested capital. Value creation potential is linked with the difference between the return on capital and its cost of capital. A company generating a 30-35% kind of return on capital will not need a precise cost of capital number (9% vs 10%). Even if it is ballpark, you know that it will not meaningfully impact your assessment. This is the reason we call 'investing the last Liberal Art'.
In case you are looking at gruesome companies, the precise cost of capital is extremely important. Gruesome companies have a low return on capital. Even the most experienced investor cannot arrive at a precise cost of capital. Therefore, valuing a gruesome category of a company is speculative at best.
“It’s obvious that if a company generates high returns on capital and reinvests at high returns, it will do well. But this wouldn’t sell books, so there’s a lot of twaddle and fuzzy concepts that have been introduced that don’t add much.” – Charlie Munger
Based on the quality of the business, a broad range of costs of capital can be worked out.
Disclaimers
Investment in securities market are subject to market risks. Read all the related documents carefully before investing.
The securities quoted are for illustration only and are not recommendatory.
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Details of the advisor
Advisor: Ankur Kapur
SEBI RIA No.: INA100001406
BASL Member ID: BASL1337