Keep an eye on the road ahead when estimating cost of equity capital

Estimating investment returns is tricky — especially, to paraphrase an old Danish saying, when dealing with the future.

Still, it comes with the territory when you're a financial manager tasked with evaluating the capital investment opportunities that will drive your firm’s strategies and determining which ones will maximize returns. One of the standard tools of the trade is cost of equity capital estimation (COEC). While this estimate strongly influences corporate capital budgeting decisions, exactly how it’s calculated and what assumptions drive the estimate can vary.

A study examining actual practice data from more than 300 senior-level executives suggests that financial managers rely primarily on assumptions based on past returns in their COEC estimation practices — a finding that University of Notre Dame accountancy professor Stephannie Larocque and her co-authors wrote, “raises concerns regarding the efficient allocation of capital.”

For a closer look at the methodology behind COEC calculations made in the real world — as well as the quality of those determinations — Larocque, the Notre Dame Associate Professor of Accountancy and EY Faculty Fellow in the Mendoza College of Business, along with researchers Alastair Lawrence of the University of California-Berkeley and Kevin Veenstra of McMaster University, examined responses to a cost of capital estimation survey conducted by the Association for Financial Professionals (AFP).

The survey queried AFP members, many of whom held corporate treasury or other high-level financial positions at S&P 500 firms and would “have their finger on the pulse of their firm’s cost of capital,” Larocque said. Respondents indicated that they largely relied on the Capital Asset Pricing Model (CAPM), which she found unsurprising considering that this model is widely taught in business schools. “We said, ‘All right. Well, given that they come up with their cost of capital estimates in that way, how well do those estimates perform?’”

To find out, the researchers mapped those firms’ COEC estimates to actual stock returns. They found that while the estimates were positively associated with realized returns in the pre-AFP survey period, the same was not true in the post-survey period. “We interpret this as evidence that managers form cost of capital estimates in a backward-looking manner,” Larocque said.

Any estimation model, however, is only as good as its inputs. “So the risk,” she continued, “is that when you’re looking in the rearview mirror, you’re not looking so much to any changes ahead of you.”

And since the calculation derived from those inputs will be used to drive corporate strategy, it may pay to keep your eyes on the road ahead and incorporate forward-looking assumptions into the model — especially when markets are in flux. “If you go from a period of a big risk premium to a smaller one, or vice versa, sure, that’s going to really throw off a cost of capital estimate,” Larocque said.

“Make sure you look forward and think in expectation for the future and don’t just look at recent history.”

The team’s paper, “Managers’ Cost of Equity Capital Estimates: Empirical Evidence,” appeared in the July 2018 issue of the Journal of Accounting, Auditing & Finance.