I wrote:
The thing that bothered me was the a priori choice of a cost of equity
capital of 12%. I believe the rationale for this is that this is an historic return required for equity capital. Though this is at least a rational rationale, I had (and have) some doubts about using an historical cost of equity (derived from all equity investments). My concern was that this would set excessively high or low hurdles for management, since it did not take into account the riskiness of their industries, etc.>
Then Reginald Middleton replied:
A base return requirement, the historical equity risk premium over long term riskless securities for the equity market is used as a start (I use 5.85% which encompasses the entire history of the equity market, spanning two market crashes, several recessions, many booms and busts and no less than 5 (or 4?) wars. This is then adjusted by the risk specific to the individual company or corporate division. A combination of deleveraged beta and business risk is used to determine this figure. When added together, you get the adjusted risk premium for the entity in question.
Reginald, that sure was a mouthful. Anyone who dislikes CAPM jargon is surely long gone by now ;-) Seriously though, thanks for the explanation.
Anyhow, my understanding of your technique (please correct me if I'm wrong) is that the net result of your valuation will be zero, if management is delivering exactly the "required cost of equity". Exceptionally well run businesses will return an excess, and poorly run ones will show a deficit (management is failing to earn the "hurdle" cost of equity).
So, you would expect a company showing such an excess to outperform (in a risk-adjusted manner) the general market, and vice-versa.
I often wonder though, about the relevance of using historical equity premiums. Historical equity premiums simply reflect what people achieved (in the past). Perhaps they got more than they expected? Perhaps less?
My "problem" with using (risk-adjusted, as you have corrected me) equity risk premiums is that I don't think the risks and rewards people have assumed and earned in the past should completely control my criteria for valuation (though of course they are very important historical data, that should always be used to temper one's own bullishness or bearishness. Don't let historical data lead you into a trap, but don't ignore it when it's trying to save you! ;-)
My interpretation of Mr. Buffett's success is that he insists on understanding a company so thoroughly, and therefore having such confidence and certainty in the company's prospects, that he no longer needs to demand a risk premium. In other words, he seems to have been willing to "pay up" for KO, DIS, AXP etc, even though (at the time) they did not seem undervalued to the rest of the market. As far as I know, his various big purchases in the 1980s did not look to be particularly astute at the time. Yet even ignoring the portion of his returns due to an overexuberant stock market, he seems to have outperformed.
In the face of certainty, one can use a discount rate of 0% over risk-free, and then see if a company appears to be undervalued. You can make investments that an outsider (without your knowledge and certainty) would (rationally) assess as overly risky. But if you use no leverage, and can commit capital for what might be a very long time (necessary conditions to avoid going broke in the short run), your "overly risky" investments will pay above-market returns (if your certainty was in fact correct ;-)
In other words, you will have earned a return of "risk free + risk premium", when in reality the risk you assumed was "risk free".
The price of insisting on this absolute certainty and confidence, of course, is that it greatly limits one's choice of stocks. Perhaps it eliminates everything. My "circle of competence" is pretty darn small, when I am honest with myself ;-). For example, I am an aerospace engineer by training. Two years ago I thought I'd be really clever and analyze Boeing - after all, I'm smart and know all about this stuff, right? The reality is, I don't have a clue how Boeing works, whether it is a cash cow or a cash sink, whether they make money on every plane they sell or lose money on every one, and what their prospects for the next 20-30 years are. I know they make wonderful airplanes, and fully expect them to be making wonderful airplanes in 20-30 years, but I don't have a clue as to whether they will increase shareholder value above the risk free rate over the next 30 years, rather than acting as a long term charity for the betterment of aerospace engineers and assembly workers, management, suppliers and customers. I'm sure that everyone around Boeing will do fine (employees, management, parts suppliers, etc) - but I have no clue how common shareholders will make out.
- Daniel |
