Ke = Rf + B x MRP
Ke = Cost of equity
Rf = Risk-free rate (Basically, a treasury bond [long term])
B = Beta
MRP = Market Risk Premium
An except from Warren Buffet’s annual letter to shareholders:
From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.
I’ve talked to a number of people about how stocks are priced and how they’re priced wrong according to the Capital Asset Pricing Model (CAPM). This is because CAPM assumes that stocks are perfectly priced which is based on the efficient market theory. A quick note on efficient market theory, it basically says that all equities are perfectly priced all the time. Meaning, a stock will be perfectly priced compared to everything in the market.
I feel like when you learn about pricing things in finance, that the efficient market theory is like a fairy tale. You want to believe all of that is true. In reality, it’s just used as a process used to make you feel warm and bubbly until you get hit with the harshness of reality. The reality is that markets will always be inefficient (at least in my opinion).
This is not to say markets become more efficient, if that makes any sense. As more and more people enter the market, instruments should be priced better. This is not to say that because the NYSE has the largest amount of volume that it is the most perfectly priced market. But ideally it should be. People’s sentiments go into pricing stocks. People are not always rational.
This brings us back to this concept of CAPM and beta. I read an article in the Financial Times also articulating the same point Mr. Buffet brought up in his annual letter to shareholders. What both are saying is that beta doesn’t accurately represent risk, it just represents how much a stock moves in according to a major market index. In the US, most people think of this as the S&P 500 index.
Therefore, in the US, let’s say there’s a stock ABC. If it’s beta is 1, that means when the S&P goes up one point, ABC will go up one point (on average). If it’s beta is 2, ABC goes up two points (again on average) when the S&P goes up one point. In the same scenario that the S&P goes up a point and ABC’s beta is -1 (which can happen but rare), ABC goes down one point (on average).
Now, let’s say a ticker, we’ll use BSC as an example, has a beta of .7. This doesn’t reflect the fact that they own a bunch of worthless bonds and that they are highly dependent on that portfolio for liquidity and/or solvency.
Most people will know that BSC was the symbol for the now defunct Bear Stearns. I really don’t know what their beta was in 2007 before it tanked. But I know it didn’t reflect the price of the stock properly. And that’s because most reports base their prices on CAPM.
(This may have a continuation)