From a reader on last night’s piece:
David, can you expand on this – ” I would revise the concept of the cost of capital to make it credit-centric. All the efforts to calculate the cost of equity capital from equity market correlations are bogus. They don’t make any economic sense. In most cases, the cost of equity should not exceed the yield on an average CCC bond.”
All valuation classes teach the equity market correlation method so it would be interesting to hear your views.
Equity exists in many forms. In securitizations, equity is the tranche that takes the first loss and controls the deal. In a mutual insurer/bank/thrift, etc., the book equity is held by the dividend-receiving policyholders. The real equity is held by management, who actually control the place as the dividend-receiving policyholders will not vote them out. In a credit tenant lease, there is the guy that owns the property, and typically he puts up a teensy amount of equity because there is a “credit tenant” - one that has an investment grade rating.
The mortgage is secured by:
Then there are more normal examples, like public and private equity. The ownership is clear, though control varies considerably, considering the stakes that control investors have.
Contingent Claims Theory
Leaving aside options, the equity of an investment is the most volatile investment that funds the assets of an economic entity. The equity of an entity controls it and possesses a valuable option - to abandon it all and hand the company over to the next most junior investor.
Option valuation can tell us a lot about about the cost of capital. The put option inherent in any debt can be measured, giving the following observations:
Holding the equity is holding control, with a complex option to adjust the capital structure including the possibility of giving up control under bad conditions, or selling out under good conditions. But now consider options on the equity - those options also imply a cost of equity capital:
Cost of equity is a function of the overall volatility of the value of corporate assets, and the degree of leverage the firm employs. This is how the cost of equity should be calculated. Using a method like this, I believe the estimated cost of equity would be lower than what MPT models would produce, and the equity would display significant optionality, having very low returns under stress - and very high returns under the best scenarios.
If we calculate the cost of equity like this, it will be an enhancement to DCF, and not require the bogus assumptions of MPT:
David, can you expand on this – ” I would revise the concept of the cost of capital to make it credit-centric. All the efforts to calculate the cost of equity capital from equity market correlations are bogus. They don’t make any economic sense. In most cases, the cost of equity should not exceed the yield on an average CCC bond.”
All valuation classes teach the equity market correlation method so it would be interesting to hear your views.
Equity exists in many forms. In securitizations, equity is the tranche that takes the first loss and controls the deal. In a mutual insurer/bank/thrift, etc., the book equity is held by the dividend-receiving policyholders. The real equity is held by management, who actually control the place as the dividend-receiving policyholders will not vote them out. In a credit tenant lease, there is the guy that owns the property, and typically he puts up a teensy amount of equity because there is a “credit tenant” - one that has an investment grade rating.
The mortgage is secured by:
- The property
- The senior unsecured credit of the “credit tenant,” whose lease payments pay the mortgage, and go directly to the lender, and -
- the equity owner.
3rd party Ad. Not an offer or recommendation by Investing.com. See disclosure here or remove ads.
Then there are more normal examples, like public and private equity. The ownership is clear, though control varies considerably, considering the stakes that control investors have.
Contingent Claims Theory
Leaving aside options, the equity of an investment is the most volatile investment that funds the assets of an economic entity. The equity of an entity controls it and possesses a valuable option - to abandon it all and hand the company over to the next most junior investor.
Option valuation can tell us a lot about about the cost of capital. The put option inherent in any debt can be measured, giving the following observations:
- The more of the company that is financed with debt, the greater the risk of owning the equity (the default option is near the money); the higher the cost of equity.
- The more volatile the economic results of the company, the higher the probability of bankruptcy; the higher the cost of equity.
- The underlying volatility of a company’s assets radiates out through it liabilities, with liability volatility increasing as liability claims become more junior.
3rd party Ad. Not an offer or recommendation by Investing.com. See disclosure here or remove ads.
Holding the equity is holding control, with a complex option to adjust the capital structure including the possibility of giving up control under bad conditions, or selling out under good conditions. But now consider options on the equity - those options also imply a cost of equity capital:
- The more volatile the at-the money option is, the higher the cost of equity. (And the higher will be bond spreads…)
- Another way to think about it is how expensive it is to set a floor under and equity investment. Volatile companies have higher insurance premiums for their stocks. That implies a higher cost of capital.
- Using options, we can create pseudo-bonds, where we can lock in a certain range of returns.
- A capital structure hedge fund can trade corporate debt and CDS [Credit Default Swaps] against equity options — they all price off of the volatility of corporate assets in the short run.
- For any capital structure, the return on the assets can be modeled over a variety of credit scenarios. Those returns can translate into returns for the various liability classes — e.g. trade claims, bank debt, senior unsecured debt, junior bonds, preferred stock and equity. Given the current prices for each class, the yields and yield spreads can be calculated, as well as the probability and severity of loss.
Cost of equity is a function of the overall volatility of the value of corporate assets, and the degree of leverage the firm employs. This is how the cost of equity should be calculated. Using a method like this, I believe the estimated cost of equity would be lower than what MPT models would produce, and the equity would display significant optionality, having very low returns under stress - and very high returns under the best scenarios.
3rd party Ad. Not an offer or recommendation by Investing.com. See disclosure here or remove ads.
If we calculate the cost of equity like this, it will be an enhancement to DCF, and not require the bogus assumptions of MPT:
- Risk is risk of monetary loss, not correlation to an index
- Beta is not a stable parameter; neither are correlation coefficients.
- This fits with the way that actuaries would price complex credit insurance policies, if they had thought hard enough about it.
- This fits with the contingent claims theory, which legally describes the claim structures for competing classes of liabilities.
Which stock should you buy in your very next trade?
AI computing powers are changing the stock market. Investing.com's ProPicks AI includes 6 winning stock portfolios chosen by our advanced AI. In 2024 alone, ProPicks AI identified 2 stocks that surged over 150%, 4 additional stocks that leaped over 30%, and 3 more that climbed over 25%. Which stock will be the next to soar?
Unlock ProPicks AI