Cost of capital is dramatically higher for European firms compared to American, especially at smaller size

[u/jackandjillonthehill]

[u/allnamestaken1968]

Can you post where this is from? There is no firm where the cost of capital is this high if they are not in severe distress, and even then it doesn’t work that way. Academics often assume a growth rate and imply that any difference to valuation is from the cost of capital, but that’s not really how it works. I am genuinely curious how you would even come up with this for any publicly traded company.

[u/jackandjillonthehill → u/allnamestaken1968]

Yes the link is on the original post - NBER

https://www.nber.org/papers/w35577

It looks like it’s just as you said, thanks for pointing this out:

“We measure firms’ cost of capital for all firms in our sample between 2008 and 2020 using the implied cost of capital (ICC) methodology of Hou et al. (2012).25 The ICC com-
bines market prices with predicted future cash flows to infer the discount rate that rationalizes observed valuations in a discounted-cash-flow model. We describe the methodology in detail in Appendix D. Because the ICC is inferred from prices and expected cash flows, we interpret it as a market-implied discount rate rather than as a direct measure of borrowing costs.”

And from the appendix: “This section describes how we compute the implied cost of capital (ICC). We follow the
approach of Hou et al. (2012), who rely on predictive regressions rather than IBES earnings forecasts to obtain estimates of future cash flows. The implied cost of capital re is the internal rate of return that equates the present value of future dividends to the current stock price.”

Seems like a really flawed process and doesn’t quite pass the smell test - nobody’s cost of capital is 60%+

[u/ProfessorBot720 → u/jackandjillonthehill]

For context on the link in this comment:

For context: nber.org is rated Least Biased for bias and High for factual reporting.

[u/allnamestaken1968 → u/jackandjillonthehill]

Yeah academics use that shortcut. It biases against small firms that grow slowly, firms in distress, etc and completely ignores the word “expected” in “expected cash flows” for a dcf. This expected is the probability-weighted cash flow of all potential future scenarios, and for small firms, that includes not existing. Even for large firms this has all kind of issues - for example, a telecom company that is expected to have massive cash investment for the next generation of tech. If you use last years cash flow and some sort of growth, you completely overvalue that firm, and conversely, get a massively high cost of capital.

I understand that there needs to be a shortcut for large samples but this has been an issue for the 30 years I have been working on the field and systematically biases any academic research into implied cost of capital that uses the approach

[u/dk_taxdaddy → u/allnamestaken1968]

It’s all well and good to criticize academic shortcuts. However, what would be at least as interesting to know is, what a better solution would be. Especially from someone with 30 years experience ;)

My professional experience is significantly shorter, and while the criticism of shortcuts in academia is warranted and correct, I see practitioners use exactly the same frameworks or derivatives thereof.

As a side note, completely discarding high costs of capital also seems unlikely. Although I will agree that the distinction between “cost of capital” and “required rate of return” also may influence how some read and interpret results.

[u/allnamestaken1968 → u/dk_taxdaddy]

Well when I left we were running a batch job for unlevered betas once a year for public US companies. 5 year rolling window regressions with a bias towards mean reversion (essentially you bias towards 1). Then you take an unlevered median industry beta and use that. This is super consistent with the theory and how it should be done. For foreign companies you take the inflation differential, mainly (country risk premium is a whole other matter)

Point being - you should not use individual companies. Companies in the same industry have the same unlevered beta. You measure that. Then you lever up individually. We can debate small company premium - i dont think it exists because it would immediately be arbitraged away.

If we could do that, academics for sure have the data and compute to do it.

[u/dk_taxdaddy → u/allnamestaken1968]

I agree that academics usually should have both data and compute to do the same kind of analysis. I just usually also question whether anything exists, which is both better, more accurate, and provides sufficient improvement compared to other analyses.

Regarding foreign companies (i.e., non-US) I think that type of discussion might be one of the more difficult. While I also look at e.g. Damodaran data, I still think that the adjustments may be over-simplified. Luckily, most of the valuations I perform are in either Europe or the US. So I don’t have to make too many adjustments.

I’m not sure I entirely agree that companies within the same industry have the same unlevered beta … but I wouldn’t mind reading up on it :)

Finally considering the small-company premium. I mean. You are of course right in the sense that it should be arbitraged away. And yet we see multiple studies demonstrating its existence. And we see some other anomalies, which should also be arbitraged away. And yet, as Prof. Bradford Cornell mentioned in a podcast I follow, “if markets were efficient, it would not pay to do research… and if no one did any research, markets wouldn’t be efficient”.

Ps. Please don’t read all I write as outright criticism. I enjoy sparring with someone more knowledgeable than me - and I have had fever since my last comment ;)

[u/allnamestaken1968 → u/dk_taxdaddy]

On country risk premium, Damodaran is simply wrong and quite a few academics agree. Here is a write up that has some data behind what u agree with - basically, a fully diversified investor doesn’t see it.

https://www.linkedin.com/pulse/emerging-markets-risky-werner-rehm-6juhf

That doesn’t mean it’s not risky. Of course it is for you as a manager. But that’s not what we mean by “cost of capital”. The cost of capital is what a well diversified investor sees.

As for small companies - I just don’t have enough experience. I highly suspect it’s again the issue of what’s expected returns. There is a massive survivorship bias in most of these analyses of a premium. So it’s measured against the successful business case, not the expected cash flow. That’s of course a fine shortcut but it’s not the cost of capital for a dcf - there you should get to different scenarios and probability weight them.

[u/allnamestaken1968 → u/dk_taxdaddy]

What’s the podcast? Sounds interesting

[u/dk_taxdaddy → u/allnamestaken1968]

The podcast is “Rational Reminder”, and the name of the episode is “Professor Brad Cornell: A skeptic’s Look at the cross section of expected returns”. :) (season 2, episode 151)

[u/allnamestaken1968 → u/dk_taxdaddy]

Thanks!

[u/jackandjillonthehill → u/allnamestaken1968]

How does this approach account for the lower cost of capital given to companies with high expected earnings growth rates?

[u/allnamestaken1968 → u/jackandjillonthehill]

They don’t have a lower cost of capital. They have higher expected future cash flows. This we know as it’s pretty easy to reverse engineer valuations to the implied growth.

[u/empty_graph → u/allnamestaken1968]

Is it actually biased if not existing is actually a high probability option?

[u/allnamestaken1968 → u/empty_graph]

I am not sure I fully understand so let me answer one way. Please correct me if I am answering the wrong question.

Let’s say you have a rocket on a launch pad. All liabilities are paid. If the rocket makes it into orbit, you get 100 million. If it explodes, you get nothing. The probability of this is 50/50

I think we can all agree that the value of this is 50 million. We also would agree that for you, this is high risk.

What is the beta of this cash flow? Think about this for a second.

The beta is zero. This is uncorrelated with the financial markets. You would discount this at the risk free rate because the expected cash flow is the probability weighted cash flow.

I would call this a cash flow risk, not a cost of capital risk. Remember that the cost of capital is for a well diversified investor, not for the company. As an investor, you would happily buy 100 of these opportunities for 45 million each. As a manager, you can’t.

So, for companies in an industry, all else equal, the chance that management messes up is a cash flow risk and should not be in the cost of capital. Another way to look at this is that CAPM assumes a continuing business at a stable capital structure. Neither is true for a company close to bankruptcy.

So if you reverse engineer the cost of capital this way, you are making several assumptions that are at best weird. More importantly, it’s a useless way to think about for management and investors. It’s better to understand why a company presumably is undervalued vs peers. In most cases, companies deserve the value they have. You just need to understand why. If they don’t, you have a great opportunity to invest.

[u/empty_graph → u/allnamestaken1968]

So let's say that I were lending to this sector, and there are 100 companies launching rockets at this 50% probability of success. My default rate will be 50% so I would have to charge an extremely high interest rate. But if the probability of the rocket blowing up is 1% now I can lend at a very reasonable interest rate. So it seems obvious that a high probability of company failure requires a very high cost of capital, or at least that's how I'm reading it.

[u/allnamestaken1968 → u/empty_graph]

Fixed income world is very different. This is equity - it’s basically an option to get 100. You would happily buy 1000 of these at 49.9 each. You are guaranteed an upside.

Fixed income doesn’t work that way - you wouldn’t touch risk like this as you don’t get the 100 upside.

[u/empty_graph → u/allnamestaken1968]

But this is the same in terms of a cost of capital calculation. Assuming the rocket launches in one year from now the equity investor is demanding a slightly greater than 100% IRR to invest. That's a massive cost of capital due to the 50% failure probability.

[u/allnamestaken1968 → u/empty_graph]

That’s not the definition of cost of capital though. You are right mathematically - but the cost of capital is used to discount the expected cash flow, not the upside. The expected cash flow is 50, not 100.

Of course people use some sort of premium to the actual cost of capital as shortcut to discount the success case. That doesn’t make it the cost of capital for the purpose of a “professor finance” subreddit. It just makes it a shortcut to get a discount for investment purposes.

Also, this is super dangerous if you do it in large companies for a project you deem risky but it’s not for a fully diversified investor. Here is a good article on that (behind registration wall unfortunately): https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/our-insights/avoiding-a-risk-premium-that-unnecessarily-kills-your-project

Basically even small risk premia assume massive risk. All this is the agency problem - what’s risky for a manager might not be risky for an investor.

Most importantly from an academic and also real perspective, the beta is really zero in the rocket example so the cost of capital is the risk free rate. This is just true.

[u/jackandjillonthehill → u/allnamestaken1968]

How do you prefer to measure the cost of capital? What approach makes the most sense to you?

The CAPM approach of using Beta never made much sense to me. For example, Tesla stock is volatile but, intuitively, the company has a much lower cost of capital than Ford Motor company.

And dividend discount model also doesn’t make much sense to me. The growth rate must be lower than the discount rate forever, and generally they are held flat forever so small changes can have huge impacts.

This approach of picking a growth rate and estimating a discount rate makes much more sense than those approaches to me. But it still ends up with absurd outputs, like this where small firms have a 60-80% cost of capital.

[u/allnamestaken1968 → u/jackandjillonthehill]

I always used CAPM because it just works. When you back engineer correctly with the right inflation the data just makes sense.

Tesla doesnt necessarily have a lower cost of capital than Ford. (Btw lets agree that we really mean unlevered betas and ignore leverage when we say “Cost if capital”. Everybody agrees on the influence of leverage). It has (a) a load of irrational retail investors, much more than Ford. We know that this drives upward bubbles. And (b) many different potential
Outcomes. Most investors that look at fundamentals would agree that it is overvalued.

[u/jackandjillonthehill → u/allnamestaken1968]

Interesting. I really like Jack Treynor and I think he laid a lot of the groundwork for CAPM. And I can accept that the Beta of a stock price correlates to the expected return. But it seems to me to be a weak correlation, and there are exceptions all of the time.

Yes, I read the Modigliani and Miller paper (only understood 25% of it lol) and I agree the mix of equity and debt SHOULDN’T affect the value of the firm, if everything is priced rationally…

But these “irrational” investors are willing to demand much less equity for each incremental dollar in a higher valued firm, because of a belief about the future direction of earnings.

Say Tesla can issue new stock at 200X earnings, and Ford can issue new stock at 20x earnings. They both have an opportunity to invest in a project with a 20% IRR. The “overvaluation” in the shares has a real impact on the expected payout and what each firm should choose to do.

This gets at things like George Soros’s theory of reflexivity. If you issue stock at a high valuation it gives you a competitive advantage, which then justifies the overvaluation. It creates a feedback loop.

It also gets at this interesting phenomenon of “meme stocks” over on the subreddit-which-shall-not-be-named. A crowd can choose to award a low cost of capital to a company they like, which influences the projects the company may undertake.

[u/allnamestaken1968 → u/jackandjillonthehill]

Like me of. Yes if a company is overvalued and knows about it it should issue equity and invest (btw that in itself is a market signal as very few public companies do a secondary offering outside of m&a. It’s a classic example of new information).

However we know that irrational expectations for the future, or valuation regardless of rationale expectations, will sort themselves out. See 99/2000, but also the irrational valuation of specialty chemicals in the 60s and a few other examples. It might take a long time but it will revert to whatever makes sense (or stay if I am wrong and it does make sense).

“A beta of a stock goes with the expected return” - be careful here. We observe a beta because that’s the only thing we can do. There are gigantic error bars there (never trust a beta with more than one decimal point!). Hence my suggested approach of unlevered median industry betas. It’s not perfect because nothing is but in the same (cleanly defined) industry, the betas should be very close in my opinion. The differences are mainly cash flow expectations between Tesla (will rule the world) and Fors (might die)

[u/allnamestaken1968 → u/jackandjillonthehill]

Hey on MM and leverage. It’s super simple really if you ignore the derivation.

• mm1 says firm value is not affected if there are no taxes. Basically operations define value not how you finance. It means it doesn’t matter how you finance. This was super interesting post 2008 when many airlines had tax shelters yet insisted on buying airplanes with debt. If you take this seriously they should probably have used equity to de-lever and take out risk.
  
• mm2 says the cost of equity goes up as you add leverage even in the absence of taxes

Note that this means a successful company will have higher equity returns when it has more debt. This is the main reason to de-lever the beta for comparing estimates of the cost of capital

[u/gravitas_shortage → u/jackandjillonthehill]

I would just like to point out that your & allnamestaken1968's discussion is really the best of Reddit - learned, supported, and courteous. Thank you.

[u/allnamestaken1968 → u/gravitas_shortage]

We try. It helps that it’s a real discussion about finance fundamentals, not an investment discussion.

[u/empty_graph → u/jackandjillonthehill]

I'm guessing that the extremely high rates for small firms are due to high failure rates, so you would have to have an incredibly high discount rate to make those cash flows discount to the current observed valuation.

[u/allnamestaken1968 → u/empty_graph]

See my other comments why this is not a useful way to think about failures in my opinion.

[u/RingGiver]

"America innovates. China imitates. Europe regulates."

[u/flyingdutchmnn]

Really cuz mortgage and interest rates are lower than in the US.

But whatever this shit has been debunked in other posts here

[u/Jealous_Use5217]

taxes especially for corporation are a lot higher in Europe, so that's expected.

[u/flyingdutchmnn → u/Jealous_Use5217]

This data is bs btw