April 2016 Determining the cost of equity MACROECONOMIC FACTORS AND THE DISCOUNT RATE

Dr. Ghadir Abu Leil-Cooper Head, EMEA & Global Frontier Markets Equity Team

Baring Asset Management, London

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Executive Summary While the cost of debt is relatively easy to determine from the observation of rates in the capital markets, the cost of Cost of equity (COE) is the minimum demanded by equity is not observable, and must be estimated. equity investors for committed capital. Since the varies from market to market, and is dependent on economic and There are competing theories around how best to do this. For our monetary conditions, the cost of equity varies too. Determining purposes, the cost of equity can be approximated by the Capital this can be challenging, introducing complexities and issues of Asset Pricing Model (CAPM). consistency between investment desks. In order to take into account the macroeconomic conditions One way of dealing with the challenge is to follow a standardised companies operate in, and in a bid to combine the discount rate approach. Having reviewed a number of different alternatives, we (cost of equity) with the period we forecast earnings for, we have have decided that it is appropriate to take the Capital Asset decided to use centralised inputs. These are as follows. Pricing Model (CAPM) as a guideline, and to centralise the inputs for risk-free rates as well as market equity risk premiums. Risk-free rate 1. We use the IMF data series for inflation as a starting point. It is Our approach allows us to determine a COE (or discount rate the best and most complete data series we have which is used to value companies) across markets, making it possible to directly comparable perform comparisons between companies in different markets. In (http://www.imf.org/external/ns/cs.aspx?id=28). addition, the approach we describe in this paper makes full use of the company-specific expertise of our equity analysts. 2. We take the IMF’s inflation compounded annual growth rate (CAGR) for the next five years for the market where the Our investment horizon for forecasting company earnings is five company operates. years, and we wanted a discount rate that matches this time horizon and is not determined by the market. To that effect, we 3. To determine the risk-free rate, we decided to add 2.25%. use five-year IMF inflation forecasts in the calculation. That’s the average difference between the 10-year bond yield and inflation in the US since 1949. This allows us to draw on a well-established and reliable data series, something that is not always available in emerging or Equity risk premium frontier markets. As we take an unusually long time horizon of 5 years ourselves when analysing companies, we believe these 4. We continue to draw on the quality and length of data available data series are appropriate. in the US when establishing the equity risk premium.

Our approach has the advantage of simplicity, making it 5. At different times, different markets have demanded different straightforward to adjust for specific macroeconomic events in a risk premiums, but it is the longest series we have. In our timely fashion until expectations catch up. approach, developed markets are discounted at 4%, emerging and frontier markets at 5%. While there are clearly some issues around using a centralised methodology across very different markets, we believe the Company beta flexibility of this approach and the ability to compare companies 6. Finally, rather than using market data to calculate beta, our in different markets easily, in a way which accounts for analysts will assess company specific risk, in a range of 0% to macroeconomic risk, is a powerful advantage. 2%, and environmental, social and governance (ESG) factors, This paper sets out some of the thinking behind our decision. It is in a range of -1% to +2%, for that part of the equation. not a research paper, and it is not intended to provide a detailed It is worth noting that the result of this is a discount rate that mathematical proof. It is, however, provided as a service to our reflects only the cost of equity, in other words, as if the business clients, and we hope that it proves valuable. is financed solely through equity. This is intentional. Cost of equity and the Capital Asset Pricing Model In , the cost of equity is the minimum rate of return demanded by equity investors to compensate them for the risk of owning the company compared to another investment they may otherwise make.

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This is quite different from the weighted average cost of capital, (ii) The Equity Risk Premium which analysts tend to use for discounted cashflow calculations. The second part of our calculation involves looking at the equity risk premium. (i) The Risk-free rate 4% for developed markets Looking at the different parts of our equation in more detail, the Equity Risk Premium = risk-free rate is usually what a bond investor demands to be 5% for emerging markets compensated for holding a bond. This has to take account of inflation and allow for a real positive return. It is not possible to determine an exact number for the equity risk For our purposes, the risk-free rate be can determined as follows. premium, and not all markets would have the same outcome if you examine historic data. We are using data from the US again, IMF local inflation as this market has the longest available history. Risk-free rate = + 2.25% forecast 5y CAGR For example, the equity risk premium for the US has varied through history, and has recently come down. However, as we are taking a long-term series, we believe that 4% is appropriate

for developed markets, and 5% for emerging and frontier. This is We have decided to use inflation as our starting point rather than, supported by empirical evidence from data showing what for example, government bonds, to avoid being unduly affected markets demanded for return on equity over long periods. by short-term pricing in the bond market, and to determine a rate that can be used over the full investment cycle. Figure 2: Calculation of the equity risk premium for the US

S&P 500 3m T-Bills 10y US Bonds ERP v ERP v CASH BONDS Figure 1: US CPI and 10-year rates over the very long term 1928-2014 9.597% 3.488% 4.999% 6.109% 4.598%

1980-2014 10.830% 4.325% 8.157% 6.505% 2.673%

1990-2014 9.664% 2.721% 6.286% 6.943% 3.378%

1995-2014 8.033% 2.331% 5.311% 5.703% 2.723%

Source: Baring Asset Management, June 2015.

Since 1871, which is the longest time series available, the average difference between bond yields and inflation has been 2.36%. However, as you can see, the early parts of the data series are volatile and less relevant. Source: Barings and Damodaran, as at September 2015. Please note that the average calculation is based on a geometric average.

Our preference instead is to use the average difference between 1949 and now, which is 2.25%.

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Exceptions to the above calculations As most quality companies have a β of less than 2.0, adding between -1% and 4% (to allow for company specific risk and IMF inflation ESG factors) can therefore be said to be mathematically equivalent to multiplying the β by the equity risk premium. There are always periods of stress when the data does not predict what you expect. Discount rates calculated using the previous method for emerging markets may predict lower than As the same company will have different β to different market developed market discount rates or between markets. This is indices, our preference is to define it in this way for greater often down to deflation, or a lack of inflation. We have, therefore, consistency and to ensure that appropriate risks are allowed an override to account for this. accounted for.

One such example is the case of Italy versus Germany, where Company specific risk, therefore, allows our analysts to reflect lower forecast CPI for Italy imply the risk-free rate for Italy is the volatility of the business model and financial and balance lower than Germany, which we believe is not appropriate. sheet structure. Therefore, we can adjust for it by using one European rate.

Including company specific risk and ESG factors in the Furthermore, in exceptional market conditions we will review our calculation rather than beta allows us to accommodate different discount rate and may add to the equity risk premium in times of companies in the same market with very different company market dislocation. specific risks. For example, banks are more regulatory sensitive and cyclical so have a higher degree of specific risk than In particular, when the market is at risk of default, or when politics consumer companies or breweries. Similarly, companies with are emerging as a risk factor, we can add up to 5% to the equity stronger balance sheets should be discounted less than more risk premium. We saw this in Greece, Russia and Brazil in leveraged companies. 2014/15. We make these adjustments to reflect macroeconomic breakdowns. This allows us to adjust for any such dislocations quickly, before analyst and inflation expectations catch-up. Conclusion

(iii) The Company’s Beta (β) Bringing everything together, the equation we use for the cost of For the purposes of the Capital Asset Pricing Model, we define equity, or discount rate when valuing companies, is as follows. the company’s beta as follows. Cost of Equity

(Discount rate) = Company specific risk in a range of 0% to 2% Company Company’s Beta Risk-free Equity Risk = + + + specific + ESG (β) rate Premium ESG factors risk in a range of -1% to +2%

In effect, this adjusts the equity risk premium between the range While the framework we have come up with for calculating the -1% to +4%. cost of equity is not perfect, it has the advantage of allowing us to compare companies within the same market or across different Although the formula for the Capital Asset Pricing Model uses the markets. beta of the company multiplied by the equity risk premium, this can be mathematically approximated by adding company specific It is easy to adapt, is flexible, and utilises centralised data and risk to the equity risk premium. analyst expertise rather than volatile market data.

Most companies have a β of between 0.8 and 2.0 to their market, Above all, by incorporating these calculations, it allows our depending on the volatility of the share. This usually reflects the portfolio managers to focus on optimising portfolios, since price volatility of the business model and financial structure. targets are already reflective of macroeconomic risk.

A β of 0.8 is mathematically equivalent to subtracting 1 Dr. Ghadir Abu Leil-Cooper from the equity risk premium, while a β of 2.0 is equivalent Head, EMEA & Global Frontier Markets Equity Team to adding 5 to the equity risk premium. Baring Asset Management, London

April 2016

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