David Merkel | Feb 24, 2013 04:02AM ET
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:
In practice, the first two offer real security, and the third is a joke, sort of. The thing is, if commercial property values inflate, there is a *lot* of leverage the CTL structure for the owner of the equity. And, if things go badly, most equity owners own the property though a thinly capitalized subsidiary. Can’t squeeze blood from a stone: “Heads, I win. Tails, you lose.”
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:
In essence, thinking like a securitization, where you have many, many levels of debt and as debt gets more junior, its yield rises as its economic prospects become more volatile. Equity is not debt, but it is the juniormost claim on the firm's assets and cash flow , even while it has control, which includes the option to adjust the capital structure. (Had to add that, because it is important, but not strictly relevant to my argument.)
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:
This is my theory of asset/liability/equity pricing in broad. Comments are welcomed.
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