The cost of equity is the return that equity investors need to be paid, or to expect to be paid, as compensation for bearing equity risk. That’s the the systemic, undiversifiable risk risk you have to bear if you hold a well-diversified equity portfolio,. It’s a key input to the capital asset pricing model (CAPM).
*
We call it the cost of equity, because from the investors’ point of view, it’s the return they need to compensate for bearing risk, that is, the opportunity cost of not investing in other, similar risk assets. Our basic assumption is that people like returns, but don’t like risk. Equities, as a general type of investment, are risky, compared with (default) risk-free government bonds. There has to be a higher expected return to make it worth accepting this risk. So the cost of equity is always higher than than the risk-free rate (more on this below).
Equity returns are very volatile, which rational investors don’t like
This might seem a bit abstract, so let’s turn to real data. If you look at the history of the US stock market over the last 150 years, you will see a very wide range of annual returns. In the best years, returns have been 30% or more, sometimes even 40%, which sounds great, as this is far more than even the worst year of inflation.
But unfortunately there are many years of bad returns, including outright falls in value.
The worst year in US stock market history was 1931, when the S&P500 index fell by 47%. It might cheer you up to know that one of the best years was just two years later, in 1933, when the index rose by more than 47%. Perhaps there is just a predictable up and down, ebb and flow in market returns? Sadly, it’s not that simple. The intervening year 1932 also saw the index fall, though “only” by about 10%.
Also, you should take note that if you start with an investment of $100 and it falls by 50% then rises by 50% you are not back to where you started. You go from $100 to $50 to then only $75.
As financial advertisements tell us, the history of stock markets is not necessarily a good guide to the future, but then what else can we use? What history tells us is that investing in a broad index of shares such as the S&P500 index is unavoidably risky, and that there will be some years that we might wish we hadn’t bothered.
But by comparing the annual returns achieved with the annual risk, as measured by the volatility of those returns, we can estimate the returns needed by investors to be willing to accept those risks. This is the cost of equity, the return required by investors to make it worthwhile taking on those risks.
The average historic return on US shares, as measured by the S&P500 index over the last 150 years has been around 9%. If we subtract inflation, the real return is 6.8%. Is that high or low? You can make your own choice. The point is that this tells us something about the returns that investors in the US stock market have achieved, and that presumably have compensated them for holding equity risk.
Thinking of the cost of equity as a premium to holding risk-free assets: the equity risk premium
Whether that historic return is a good guide to what investors now expect for the future is a very tricky question that we’ll consider another day. For now, I want to dig into the cost of equity a little further.
Recall that we’re assuming that any investor can put their money into the risk-free investment, which in this case is US government bonds, and get a risk-free return, because the US government is presumed to never fail to pay its obligations.
So, another way of thinking about the cost of equity is that there are two parts: first the risk-free return that you would get by buying US government bonds; and second, an additional return that is the compensation for bearing equity risk. We call that second part the equity risk premium, where “premium” simply means additional return. It is the extra return that investors need to receive, to make it worth bearing the additional risk of owning equities, above the risk-free return from holding safe government bonds.
Since 1900, the average return on US equities above the return on holding short term US government securities (known as Treasury Bills) has been about 7.7%. This is the historic equity risk premium for the US stock market.
This gets us a long way towards a way of thinking about the required rate of return on individual investments, which is what the executives of each company need to know, to make sure they’re aiming for a return that at least meets the needs of their equity investors. The model that gives us this is called the Capital Asset Pricing Model or CAPM, which is the foundation of most corporate investment decisions, and the main way in which investors value companies. We’ll explore CAPM another day.
We can measure the historic equity risk premium but we don’t know the expected premium
For now, let’s just explore a little further the idea of an equity risk premium. Note that although this is a very widely used concept, it’s somewhat controversial, and some people don’t even accept that it exists! The doubts come from a simple, but profound problem: we can’t actually measure what it is.
You may object that I have already offered evidence of what it is, but what I quoted was the historic result, the returns that investors in the US stockmarket actually achieved over and above the risk-free rate, averaged since 1900.
But investing is about looking forward, and comparing expected returns to expected risks. What is the current forward-looking equity risk premium, for investors considering whether to put their funds into the US stock market? It could be higher or lower than the historic figure, depending on how far we expect the future to resemble the past.
The sad, or perhaps comical truth, is we don’t know. The current, forward-looking equity risk premium for US equities and for any other market, is not observable and can only be estimated, with an unknown margin of error. Current estimates for the US equity risk premium range from about 4% to 7%, which is a huge range. Each individual investor can have their own point of view on this, but the level of share prices will be determined by the average investor view, as captured by the whole stockmarket.
There is no easy solution to this problem, which amuses people in truly scientific subjects like physics, where experiments can be done to validate the existence of particles that are predicted by theory, the Higgs boson being a famous example. Sadly, there is currently no such experiment available to economists to validate the existence, let alone the size of the equity risk premium.
But we use it nonetheless, for lack of a better alternative, and it makes a key appearance in the Capital Asset Pricing Model, which we’ll review another day.
Leave a Reply