When I write a piece, and entitle it “Toward…” it means that I don’t have all of the answers.  Typically I think I am getting somewhere, but the speed of progress is open to question.  That said, good questions and constructive criticism aid me on my way.

From Private Equity Beat at the WSJ: Toward a new theory of the cost of equity capital, on the Aleph Blog. We confess to not being entirely up on the benefits of Modern Portfolio Theory versus Modigliani-Miller irrelevance theorems, which is probably why we are journalists and not PE execs. But we nonetheless find this analysis of how to price equity interesting.

From Eddy Elfenbein at Crossing Wall Street: I like the logic, but my question is—what if a firm has little or no debt?

Good question.  The total volatility of a firm can be broken up into three pieces: financial leverage, operating leverage, and sales volatility.  Saturday’s piece dealt with financial leverage and its costs.  An unlevered firm in the financial sense still possesses operating leverage and volatility of sales.  Different unlevered firms have different costs of equity capital because they have different levels of sales volatility, and different degrees of operating leverage.

That will manifest itself in option implied volatility, which is a crude measure of what people would pay to gain and lose exposure to the equity of the company.  The cost of equity should be positively related to that.  More volatile companies should have a higher cost of equity.

Another way to look at it is to ask what is the effect on the firm if the company issues or buys back equity.  How much does the generation of free cash flow change relative to the price paid or received for equity?

Another question:

Doug Says:

October 19th, 20098:25 am

“As for common stocks, they should trade at an earnings or FCF yield greater than that of the highest after-tax yield on debts and other instruments.”

How do you account for the potential for earnings growth in this calculation? The debt investor trades seniority and (in some cases, collateral) for a fixed claim on cash flows. Common stock investors often (but not always) will earn rising “coupons” and get back value much greater than “par” at the end of his/her investment.

I realize that models such as gordon growth take this into account, but you don’t address it in your “debt plus a premium” calculation.

Doug, good point.  The FCF yield, unlike a dividend yield, as used by the Gordon and other DCF models, reflects the ability of the company to reinvest the FCF that is not paid out as dividends.  It reflects growth already in a crude way.  If the ability to grow via reinvestment is below the FCF yield, then the company may as well just sit around and buy back stock.  If the ability to grow earnings is higher (unusual), then the FCF yield will understate prospects.

That’s a crude way of phrasing it, but the FCF yield is a good place to start.

Finally, regarding my thoughts on M-M:  Take Falkenstein’s recent book — high yield tends to underperform with both debt and equity. Or consider that less levered companies tend to return better over the long haul (Megginson, Corporate Finance Theory, page 307.)

M-M, like the CAPM, does not survive the data. Low leverage is a positive factor for returns in both debt and equity, and a decent part of that is the high costs of financial stress for highly levered firms.


The idea here is to try to view the cost of equity capital as a businessman would, rather than an academic who has little exposure to the world as it operates.  Look to the degree of certainty in obtaining cashflows; the yields on various assets should rise as certainty declines.

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