- Microsoft stock analysis reveals its cost of equity could be as high as 30%, using the dividend capitalization model.
- The Capital Asset Pricing Model (CAPM) would lead to a much lower number.
- Here's a look at the two commonly used methods using Microsoft as an example.
Cost of equity is the required rate of return a shareholder expects to get on an equity investment. Is it possible that a rate of return which one shareholder requires, could seem high or low to another shareholder? I think that is very much possible. And hence, the argument related to cost of equity arises, on whether it is too high, too low or just what is expected.
There are two best known ways to calculate Cost of Equity; the dividend capitalization model and the Capital Asset Pricing Model (CAPM).
Dividend Capitalization Model:
It is the simpler way to calculate cost of equity relative to CAPM. According to this model,
Cost of Equity = Dividend growth rate (g) + Expected dividend yield
Where, sustainable dividend growth rate is calculated using PRAT model, i.e.
g = Profit Margin (P) x Retention Rate (R) x Asset Turnover (A) x Financial Leverage (T)
Seeing the inputs for cost of equity, we can safely assume that this model is suitable only for companies with stable dividend policy. The benefit of this model is that it uses the inputs from company's financial statement, which tend to give a better picture.
However, this model could lead to ridiculously high cost of equity. Like after reading my recent post, Microsoft earnings analysis, a fellow financial analyst was amazed to see a cost of equity of 30%. Well, my answer was, "the company's financials say so!"
When I used the dividend capitalization model and the growth rate estimates from PRAT model (28.09% and declining), my mean value came out to be $ 48.50.
Let us see what would have happened if I would have taken the CAPM route.
Capital Asset Pricing Model (CAPM):
CAPM is a widely used method to calculate the required rate of return. It is suitable for companies which do not pay dividend or have volatile dividend policy. According to CAPM, required rate of return is calculated using the inputs from the market.
Re = Risk free rate + Beta x (Expected market return - Risk free rate)
Now, I calculated risk free rate using the average US 10 year Treasury yield rates over the last 10 years, to accommodate for almost two economic cycles. Beta was calculated using 6 year monthly data of Microsoft stock price and S&P 500.
Since, it's a little difficult to know what exactly expected market return is, I used historical price for S&P 500 to know what shareholders got out of it in last 6 years. CAGR for S&P 500 calculated from 6 year monthly data was 17%. I assumed that this would be expected in future too.
Applying the CAPM formula,
Re = 3.27% + 0.94 x (17%-3.27%) = 16%
As you can see, there is a significant difference between the required rate of return calculated from the dividend capitalization model (30%) and CAPM (16%). However, using the low discount rate from CAPM (16%) and high growth rate estimates from PRAT model (28.09% and declining), would have given me an absurdly high stock value. Which in Microsoft's case was nearly $ 105, over 120% upside potential!
When I used CAPM calculated Cost of Equity (16%) and growth rate estimates from Yahoo finance analyst estimates, I got the fair value estimate as $44.41. I believe if we are using market inputs for calculating cost of equity, we should as well use the growth rate estimates from the market to get to the fair value estimate of a stock.
All in all, in case of valuation, yearly growth rates play a role as important as the cost of equity. Hence, I rest my case by stating that there is nothing wrong with using cost of equity too high or too low but they should be used in conjunction with relevant growth rate estimates to give a price valuation which can be called fair value estimate.
You can check out Amigobulls' Microsoft stock analysis video for a quick look at key fundamentals.