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…
Addendum: March 30, 2017
…You can find the current YTM on a company’s bonds (if they have any) at Morningstar. Here is a link to AutoZone’s. Sort by maturity date and scroll down until you find the zone where bonds are maturing about 10 years from today.
You might not find one exactly 10 yrs away and some individual bonds might have very different yields due to unknown embedded features (like being callable). As before, you have to use your judgement. In the snapshot above, there are no bonds maturing 10 yrs from today (3/30/2017) so I could just use the 3.67% bond maturing 4/1/2016. Or, I could add roughly the same delta in basis points as I see from 2015 to 2016 to the 2016 number to conclude 3.75% YTM for March of 2017.