Looking to calculate the cost of equity for a firm? Finance theory has a handful of equations to help, the most popular probably being:
You can grab a proxy for the risk-free rate (Rf) here. Just read the number out of the yield column corresponding to your holding period.
How about the equity risk premium (Rm – Rf)? Big debate as to whether to use implied or historical estimates, and over what time frame. Maybe you get a number as low as 2% or as high as 8%.
Beta can be looked up on any financial website. What is not reported is the standard error of their estimate though. It’s often huge, such that if their regression said β = 1.0, they can’t say it’s not really as low as 0.5 or as high as 1.5.
So using our equation, and the fact that right now Rf≈0%, the cost of equity for a β=1 company may be:
Or as high as… 1.5 x 8% = 12%
Fundamentalists follow the letter of the law. They use the handed-down prescription. If we secretly replace their Power Smoothie with a Mango Daquiri, we might see them loosen up and only round β to one decimal place.
Creative Thinkers respect the spirit of the law, but aren’t afraid to use their judgement. Maybe a higher beta firm often has riskier operations, but let’s not judge this book too quickly by its cover…