How do you calculate cost of equity?
Example Microsoft as of today.
COE = Risk Free Rate + beta * (Expected Market Return - Risk Free Rate)
Risk Free Rate = 4.318% (10 yr treasury yield from Wall Street Journal) Beta = .89 (CapIq) Expected Market Return = ?
Can someone help figure out how and where to find/calculate the Expected Market Return?
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Based on the most helpful WSO content, calculating the cost of equity (COE) involves using the Capital Asset Pricing Model (CAPM), which you've correctly outlined. The formula is indeed COE = Risk-Free Rate + Beta * (Expected Market Return - Risk-Free Rate). You've got the Risk-Free Rate and Beta for Microsoft, so let's talk about finding the Expected Market Return.
The Expected Market Return is a bit more nuanced and can vary depending on the source and the methodology used to calculate it. Here are a few ways to approach it:
Historical Market Returns: One common method is to look at the historical returns of the market index that best represents the market in which the company operates. For a U.S. company like Microsoft, this could be the S&P 500. Historical annual returns for the S&P 500 can be found on financial websites or databases. However, it's important to note that past performance is not always indicative of future results.
Damodaran's Data: As mentioned in the context, Professor Aswath Damodaran at NYU Stern often publishes data on market returns, risk premiums, and other financial metrics. His website is a valuable resource for finding estimated market returns and risk premiums for different countries and, by extension, can be used as a proxy for expected market returns.
Consulting Financial Analysts and Reports: Financial analysts and investment banks often publish their expectations for market returns based on their research. These reports can provide an insight into what the market consensus is regarding future returns.
Using a Proxy Based on Risk Premiums: The DCF Modeling Course mentioned in the context suggests that the assumption for the market risk premium (which is the difference between the expected market return and the risk-free rate) usually ranges from generally 5 to 8%. If you're unable to find a direct estimate for the expected market return, you could use the risk-free rate plus a risk premium within this range to estimate it.
For your specific question about Microsoft, if you don't have a specific expected market return figure, you might consider using a historical average return for the S&P 500 or refer to Damodaran's data for a more current estimate. Remember, the choice of expected market return can significantly impact your cost of equity calculation, so it's crucial to use a reasoned and justifiable figure.
Sources: On the Job With Simple As… My Research Process, On the Job With Simple As… My Research Process, DCF Modeling Course ~ Pre-training text.pdf, Notes for Technical Interview Questions, Question about expected return from deciding between BB/EB offers
The Equity Risk Premium (Market Return - Risk-Free Rate) is the return investors demand to invest in equities over the risk-free rate. In other words, it is the premium for the 'uncertainty-ness' that results from investing in equities (i.e., equities can go all the way to zero, whereas a risk-free security by definition cannot - it has no default risk).
The Market Return is exactly what it sounds like - the average expected market return. Make sure the Market Return is consistent with your risk-free rate. You chose a 10-year US treasury, so use the average return on the market (i.e., S&P500) over the last 10 years.
If you notice, the Market Return should be the expected return on the market, but with the above method, we used the historical return. The implicit assumption here is that we expect the market to return the same amount as it has done before. Although a rather suspicious assumption, this is what is used in the industry as calculating the ERP by other methods, although may be more 'consistent', does not really improve accuracy.
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