With U.S. Treasury bond yields low and the expected rates of return high, and the current stock market correction concentrating on the financial services sector and highly leveraged companies, new challenges have arisen in correctly estimating the cost of equity capital (COEC) and the overall cost of capital using traditional methods.
To address these issues, Roger Grabowski, managing director of Duff & Phelps, LLC, has published a new paper. Suggestions outlined in Grabowski’s paper range from using a longer-term average T-bond yield when developing an estimate of COEC, to considering an estimated ERP of 6%—which constitutes the upper range of research on long-term ERP—until market conditions improve. In addition, the new Duff & Phelps’ Risk Premium Report explains how to adjust the historic risk premiums for differences between the historic risk premiums observed for the overall market and current, higher forward-looking ERP estimates.
Grabowski also stresses the importance of checking the reasonableness of your cost of capital estimates. One method to use, Grabowski says, is the classic Graham and Dodd method, based on corporate bond yields and the application of an average ERP of around 4%. Another method is to apply the data provided in the Duff & Phelps’ Risk Premium Report to estimate the COEC. In particular, Grabowski’s exhibits, showing the historic equity returns based on companies’ average operating margins and their variability, can help quantify the increase in the COEC due to the increased risk of operations.
The Duff & Phelps’ Risk Premium Report 2009 is available at BvResources.com.