Where it all starts
Equity Cost of Capital (ECC) and Market Risk Premium (MRP)
Everything is relative
In valuation, everything is relative; returns, risk and even risk weighted returns. Sometimes, this seems to be forgotten by those advocating a fixed ratio to determine a price target, although not by those advocating central bank financial repression and negative interest rates in order to inflate asset prices. The cost of capital however, varies by asset class and is also dynamic; features that need to be reflected in any serious valuation system.
At GROWTHRATER, we identify the implied equity cost of capital and model its various components, as part of our service offerings, but these are derived from what are actually being discounted and priced in by markets, rather than some subjective construct that we have attempted to impose from above.
These forward looking and dynamic cost of capital are then applied against our proprietary forecasts and standardised company data to derive valuations on a market neutral basis in order to identify relative pricing anomalies and therefore opportunities.
The Cost of Capital is a product of market pricing
The cost of capital for each asset class is derived from market pricing to reflect what the future expectations being implied and discounted by markets are, and therefore also on a dynamic basis. We let the markets show us what is being discounted on a forward looking basis, rather than trying to impose a cost of capital that may have emerged from some historic relationship between equity and bond yields, which often as not reflected the markets past mis-pricing mistakes.
This is an important distinction and one that is often forgotten, as is the need for consistency in the way this figure is arrived at and then subsequently applied. It is not unusual for a bank strategist to impose a top down and fixed estimate of the ECC which maybe completely at odds with the bottom-up forecasts coming from the company analysts. Indeed, I have even seen equity departments instructed to apply an inflation assumption for their company analysis that was two percentage points below the level implied from the index linked gilt markets, as contained within the strategists ECC estimate. A seriously unbalanced equation ensued, which bumped up the company price targets by around a third; more useful as a marketing sleight of hand to flog stocks however, than providing much in the way of helpful valuation insight for investors.
Margin of error
There is no right or wrong ECC, it just is what markets make it, or to be more precise, ‘almost is’. ‘Almost is’, because however much one tries, there will always be a margin of error in any subjective component and forecast within a valuation. Again, this is not good or bad, but just needs to be identified clearly and embraced. As with bottom-up company forecasts, there are natural margins of error inherent on even the macro assumptions. This can perhaps be best seen from the two ways the ECC is often expressed
- ECC = Risk Free Return + Risk Premium
- ECC = (Operating) Free Cash Flow Yield + Growth
Modelling the planned financial repression:
The first of these (1.), is marginally informative, but a dangerous tool with which to determine the ECC and therefore market and company valuations. Spendthrift governments and their central banks however hope that you do, which is why they have been artificially depressing the yields on government bonds which have traditionally been used as a proxy for the risk free return. Potentially the impact could be immense as a simple modelling (below) can demonstrate, even of the still relatively sane 10 year US treasury yields. Using some very rounded numbers, we can see the potential impact on equity valuations from the drop in US treasury yields since the 2008 crash:
- Start position as of 2007: 5% Mkt FCF yield +5% Mkt Growth (2.5% real) = 10% Mkt ECC
Also expressed as: 10% ECC - 5% RFR = 5% RP
Since 2007 to the time of writing this (Nov 2019) however, the 10 year yield has dropped by over -300bps to only 1.6%, while the real yield (TIPS) is down -240bps to only 0.1%, with the implied inflation discount declining -90bps from around 2.5% pa to nearer 1.6% today. Assuming the real growth rate and risk premium assumptions remain unchanged (at +2.5% and 5% respectively), let’s see what impact this has on the projected operating FCF yield for the market after also folding in the change in inflation discount.
On current bond yields and implied inflation the theoretical impact on the market FCF yield therefore would be as follows:
- New ECC: 1.6% RFR +5% Risk Premium = 6.6% ECC
- New target Op FCF yield therefore:
6.6% ECC – 4.1% Growth (+2.5% real +1.6% inflation) = 2.5% Mkt FCF yield
So even assuming zero change in FCF, or changes in growth or risk premium assumptions, the drop in 10 year US real bond yields alone would support a doubling in equity market valuations as a consequence of being able to halve the FCF yield used to gross up the value. Add in the stimulus to company earnings and FCF from the avalanche of cheap money flooding into the economy, together with the potential contraction in the risk premium, as investors are pushed up the risk curve (which is the planned consequence of this financial repression), and one could leverage up these valuations even further. Use the ECB's negative real rates and one could go full retard!
Markets aren’t stupid, fortunately!
Equity markets however, are not trading on a 2.5% operating free cash flow yield, which should remind us that markets aren’t stupid. They can see when they are being played and they can recognise a government Ponzi scheme when they see one and aim off accordingly.
We’ll go into the methodology and assumptions on how we arrive at our coverage estimate of market operating FCF yields and growth assumptions in the latter sectors of this review (methodology), but the bottom line, is that excluding the lower implied inflation (which washes through the model), the drop in implied ECC since 2007 is over 60bps less than the reduction in real long bond yields. Whether this reflects a conscious decision by investors to raise the risk premium, or just aim off on long real bond yields to anticipate a reversion to a more normal market doesn’t really matter, but it highlights the dangers of driving a target cost of capital (ECC) from a top down assumption of the market risk premium (MRP), rather than working up from what the markets are telling you is implied from prevailing markket pricing.
The market dog wags the MRP tail and not vice verse.
Elevated risk premiums
An elevated market cost of capital (ECC) and implied risk premium (MRP) is not always a sign of a cheap market. Sometimes the elevated perceived risk is justified by subsequent events, as in 2006, while not in others, as in 2010 (see chart across). In 2006 equity markets failed to fully anticipated the depth of the earnings collapse in 2008/9, while then subsequently under-estimating the avalanche of free money pumped into markets and its effects.
So as investors reach forwards, which is it to be this time, as MRP levels again appear elevated; another earnings collapse as QE is replaced by QT or currency crises, or will central banks be able to keep refilling the punch-bowl and the party going a little longer, before pay-back?
Perhaps a little modelling might help!
A risk premium is there for a reason; that being the risk that the forecasts one is using to base a valuation are wrong. Recessions are rarely anticipated by consensus forecasts, which are little more than feedback loops, which is why markets aim off. What that means is that consensus estimates are invariably unreliable to use to measure valuations and risk premiums, particularly as one nears the inflection points in an economic cycle.
It is useful therefore to do what markets do and aim off either in terms of the risk premium itself, or base assumptions of the market's free cash flow and the risk free return. Although sounding simpler, doing the former and flexing the risk premium is fraught with complexity as one would need to compare with previous market expectations rather than actual outruns. For example, what turned out to be a low risk premium, may have seemed like a high one at the time when market consensus estimates were too high.
Instead, I would prefer to model the risk premium against actual comparatives and apply the sensitivities to the other determinants; the assumed risk free return and the earnings (Op FCF) basis. This way, one can aim off for a possible return to more normal bond pricing once the MMT lunacy has ended (hopefully not too messily) as well as flex the possible earnings/FCF base against current consensus expectations. In the chart (across), I have modelled my FY1 prospective market equity risk premium, which I have flexed by changes in two variables.
- Firstly by the FCF base which I have remodelled for cuts of up to -50% against current forecasts. To put this into perspective, 2009 market earnings forecasts were cut by a similar amount after mid 2008.
- Secondly, by flexing the risk free return assumption for a normalisation of real long bond yields (30 year US TIPS) back up towards 2%.
Against a MRP that has swung between 3% to almost 7% over the past two decades, the prospective figure on current forecasts and bond pricing puts it around the upper end of this range. Normalised long TIPS yields back to 2% however, and this drops to 5%, while a re-run of the 2009 earnings collapse would see it back down to 3% again.
Is it a surprise then that equity markets remain so sensitive to whether central banks have the willingness and ammunition to keep the good times rolling a little longer before hitting the buffers?