How to calculate the cost of equity or the expected rate of return of equity
What would be the proper way to calculate the cost of equity, or the expected rate of return of equity? There are at least two ways to calculate the cost of equity: Discounted Cash Flows (DCF) and CAPM. Do they provide similar values? We will calculate the cost of equity by using historical data provided in Fama and French’s 2002 paper The Equity Premium.
Some relevant data are summarized in the following table (extracted from Table I of Fama and French (2002)). All data are inflation adjusted.
| Inflation rate | Dividend ratio | Dividend growth rate | Cost of equity from DCF (summation of two previous columns) | Average S&P return | 1872-1950 | 0.99 | 5.34 | 2.74 | 8.08 | 8.30 | 1951-2000 | 4.00 | 3.70 | 1.05 | 4.75 | 9.62 |
From 1872 to1950, cost of equity of the whole equity market calculated from DCF is 8.08% and cost of equity of the whole market from CAPM is 8.30%. They are pretty close.From 1951 to 2000, cost of equity of the whole equity market calculated from DCFis 4.75% and cost of equity of the whole market from CAPM is 9.62%. The annual difference is almost 5%. The results from the two methods are very different.
In our estimation of cost of equity or future expected return of equity, which method and which result we shall rely on? DCF is a simpler method. It relies more on observable quantities.Personally, I feel DCF provides a more accurate result. But CAPM is a more prestigious theory in finance. If DCF provides more accurate results in the future, it will generate more questions about the validity of CAPM theory.
We will look further at the 1951-2000 data. In this period, the average economic return of the US businesses is 4.75%. But the financial return from holding the same businesses is 9.62%, which more than double the economic return. What is phenomenon indicate? Can this phenomenon last for long?
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